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September 9th, 2016

When Information Asymmetry is Found between Board Members and the Management Team

Running a company and ensuring its continued success is no easy task.

All hands must be on deck with up-to-date information to make the best decisions possible. This ideology is often called into question when directors feel as though they are at a disadvantage because they are not as involved in the day-to-day operations of the company like managers are. When this breakdown occurs it is known as “information asymmetry.”

There is an abundance of both scholarly and popular work done on this topic. In general, information asymmetry occurs in relationships where one party has more - or better - information than the other. This imbalance typically creates outcomes that are either unfair, or achieve poor results. In this case, information asymmetry refers to the perception that boards have less information about the organization than the management team they are meant to monitor and advise.

In situations where this occurs, management-board information asymmetry presents as a problem when there is a breakdown in communication. If there is an absence of trust, or worse yet, the presence of deception between the board and management, the board’s role as a critical governance mechanism is undermined, and poor decisions are made due to the lack of information, or the presence of inaccurate information.

The reading that I have done for this blog post examines how information asymmetry affects businesses, and how the relationship that exists between managers and directors is important to the organization’s overall success.

 

Causes of Information Asymmetry

The causes of information asymmetry are numerous, and can range from innocent to disreputable.

On the innocent side of the spectrum, the issue revolves around time. Many directors often hold not just multiple other directorships, but also full-time positions at other corporations – which then creates extremely tight time constraints on how much attention they are able to put towards each role.

Because non-executive directors have limited involvement in the day-to-day decision making processes of the company, their ability to monitor the quality of top management’s strategic decisions is often limited to board interactions. Because of this, they then rely on the CEO to provide them with relevant firm-specific information, which may not always be given voluntarily. The resulting information asymmetry may hamper their ability to properly fulfill their monitoring duties, which in turn negatively affects firm performance. 

The paradox of managers wanting advice and counsel from board members, but not wanting to be monitored or influenced too heavily is another common reason information asymmetry is a persistent problem for companies. Perhaps because of the board’s lack of on-the-ground experience at the firm, their advice can be seen as more of a guiding tool than actual decisions on strategy that are to be implemented. The disreputable component of this paradox is that the information is not being voluntarily provided because the boards monitoring could uncover fraudulent behaviour, or mismanagement.

The paradox is a particular risk for two types of firms. The first is one that has numerous independent board members. This is because an independent board is typically viewed as a tougher monitor, therefore, the CEO may be reluctant to share information with them. The second is one that is a family run organization that has multiple family members on its board. The information that is shared runs the risk of being skewed in the family's favour, but may not be what the board needs to know in order to make the best decisions for the company overall.

 

Is Information Asymmetry All Bad?

In all of the doom and gloom that the majority of the articles that I read regarding this topic, there were a couple shining lights that advocated its often overlooked positive attributes in board effectiveness.

While independent board members may not have detailed knowledge of the business, their external role, knowledge and professional experience allows them to view the company objectively, from alternative perspectives, and through different lenses than managers. This allows them to be critical in their advisory and monitoring roles. This external knowledge should be seen as complementary to the manager’s internal knowledge rather than out-of-sync or asymmetric.

Those who viewed information asymmetry as positive saw the negative issues surrounding it to be based on the breakdown in communication between management's implicit (primary direct experience) and the board's explicit (secondary sources such as papers, reports, and presentations) knowledge and information. Acknowleding the two types of knowledge or information sources as different rather than superior versus inferior made for healthier organizations as a whole.

 

 

"The very existence of the board as an institution is rooted in the wise belief that the effective oversight of an organization exceeds the capability of any individual and that collective knowledge and deliberation are best suited to the task." (Brennen & Redmond, 2001)

 

Ways to Combat the Negative Effects of Information Asymmetry

There are a number of steps that you can take to curb the presence of negative information asymmetry in your leadership teams:

  1. Independent directorsHaving the appropriate balance of independent directors on your board is key to getting the level of voluntary disclosure of corporate information needed to make educated decisions for your company’s strategy. A compromise must exist between independence and competence in order to create a group that is optimally efficient.
  2. Audit committeesHaving an audit committee as part of your board is significantly and positively related to the extent of voluntary disclosure. They ensure the quality of financial accounting and control systems. They can also influence the reduction of the amount of information that is withheld from the board.

Directors with expert knowledge in financial control can affect the transparency of their companies through the creation of more accurate information and better audited financials. A director who qualifies for financial expertise has the following:

  1. Transparency - To improve transparency and accountability there should usually be a separation of the CEO and board chairman roles, and (in the case of family run businesses) a limit to the number of family members involved on the board.
  2. A well-defined schedule for meetings - To ensure efficiency and good communication, a set board meeting schedule should be established. There were varied answers when it came to the optimal number of meetings boards should be having every year – ranging from quarterly to every 2 months. However, there was consensus that the higher the frequency of meetings, the higher the level of quality in voluntary information sharing and financial reporting.

Board directors require deep background knowledge and timely updates about firm activities and results. A higher meeting frequency puts greater pressure on managers to provide supplementary information. Because these meetings are often the only time board members get together with each other and the management team, having a high attendance rate at each meeting is seen as a way to decrease information asymmetry between all parties and promote more effective functioning of the board and management team overall.

 

Information asymmetry between board and management is a fact. The management team does have more firm-specific knowledge, and board members do depend on management for much of their information. It is also a fact that external board members have alternative perspectives and expertise to bring to the table.

The solution to the negative aspects of management-board information asymmetry is based on managers engaging with boards and being required to account for their actions and to make explicit what otherwise would be implicit and inaccessible. Keeping lines of transparent communication open will enable differing individual experiences to work together.

 

 

 

 

Sources used for this article:

Adams, R. B., & Ferreira, D. (2007). A theory of friendly boards. The Journal of Finance62(1), 217-250.

Ajina, A., Sougne, D., & Laouiti, M. (2013). Do Board Characteristics affect Information Asymmetry?. International Journal of Academic Research in Business and Social Sciences3(12), 660.

Brennan, N. and Redmond, J. (2001). Boards, Management and the Information Asymmetry Paradox.

Cormier, D., Ledoux, M. J., Magnan, M., & Aerts, W. (2010). Corporate governance and information asymmetry between managers and investors.Corporate Governance: The international journal of business in society,10(5), 574-589.

Ho, S. S., & Wong, K. S. (2001). A study of the relationship between corporate governance structures and the extent of voluntary disclosure. Journal of International Accounting, Auditing and Taxation10(2), 139-156.

Karamanou, I., & Vafeas, N. (2005). The association between corporate boards, audit committees, and management earnings forecasts: An empirical analysis. Journal of Accounting research43(3), 453-486.