Requirement:

A two-page summary report on Board of Directors effectiveness based on the attached paper.

Attributes and Structure of an Effective Board of Directors: A Theoretical Investigation Rajendra P. Srivastava Ernst & Young Distinguished Professor and Director Ernst & Young Center for Auditing Research and Advanced Technology School of Business, The University of Kansas, Lawrence, Kansas 66045, USA Email: rsrivastava@ku.edu Adi Masli Assistant Professor and E&Y CARAT Fellow School of Business, University of Kansas Lawrence, Kansas 66045, USA Email: amasli@ku.edu Matthew G. Sherwood PhD Candidate School of Business, University of Kansas Lawrence, Kansas 66045, USA Email: msherwood@ku.edu June 25, 2014 We would like to thank Mike Ettredge, Tom Kubick, Theresa Libby, Ted Mock, John Roberts, Scott Whisenant, workshop participants at the Deakin University, University of Queensland, University of Sydney, attendees of the 2013 American Accounting Association Strategic and Emerging Technologies Section meeting, 2013 - International Conference on Corporate Governance - co-sponsored by the University of Essex and Sri Venkateswara University, and the 2014 - Ernst & Young Center for Auditing Research and Advanced Technology (EY CARAT) Research Conference for their helpful comments on a previous version of the paper. The authors acknowledge research support from the EY CARAT, School of Business, University of Kansas. Attributes and Structure of an Effective Board of Directors: A Theoretical Investigation ABSTRACT Boards of directors represent the interests of shareholders and shoulder the task of monitoring managements' actions, protecting shareholder interests, and overseeing the activities of the company. Despite the large stream of academic research on the efficacy of the board of directors, there exists a lack of well-developed theory about the interrelationship of attributes that lead to an effective board of directors (Larcker et al. 2007; Brown et al. 2011; Roberts 2012). We argue that for a board to be effective, directors must possess, to some degree, the following four attributes: 1) be independent of management, 2) be able to carry out their duties in a competent manner, 3) be active or diligent in fulfilling their board responsibilities, and 4) possess appropriate behavioral attributes. We define an \"And\" relationship between board effectiveness and the four attributes and argue that a board of directors is most effective if and only if directors are independent, competent, active, and possess appropriate behavioral characteristics. First, we develop a Bayesian model on the effectiveness of the board in terms of the four basic attributes and analyze the impact of those attributes on the overall effectiveness of the board. We also introduce the concept of \"safeguard\" - i.e., the level of attentiveness by the board and its members to safeguard against unbecoming conduct, and analytically demonstrate its result on the effectiveness of the board of directors. Our research findings would not only impact future research in this area but would also impact the practice and regulatory policies. Keywords: Board of Directors, Corporate Governance, Attributes of Board of Directors, Bayesian model 1. Introduction Using the Bayesian framework, we develop a theoretical framework for the efficacy of corporate board of directors. Our theoretical framework investigates the interrelationships between four critical elements for effective boards; independence from top management, competency in performing board duties, activeness and diligence, and having the appropriate behavioral disposition as directors. Within our framework, we also analyze the effects of firms consciously attempting to safeguard against conduct that violates the board's fiduciary duties. While the constructs employed in the framework are not new, this is the first study, to our knowledge, to examine how their interconnection affects the overall effectiveness of the board. There is prevalent recognition that corporate governance arrangements, including board of directors (BOD) structure and attributes, can substantially influence corporate decisions and shareholder wealth (e.g., Core et al. 1999; Klein 2002; Larcker et al. 2007; Bebchuk et al. 2009).1 The literature on corporate governance and efficacy of board of directors is extensive, garners enormous interest, and extends its reach to such domains as accounting, finance, organizational behavior, strategic management and corporate law. When the term \"Corporate Governance\" or \"Board of Directors\" is searched using the Google Scholar website over 469,000 and 520,000 results are returned respectively.2 Taking into account there may be multiple hits per scholarly publication, it can conservatively be assumed that there are, at a minimum between 75,000 and 100,000 scholarly publications on the subject. According to agency theory, managers (i.e., agents) have desires and goals that may conflict with corporate owners (i.e., principals) and it is difficult or expensive for the principal to 1 Corporate governance involves a set of relationships between a company's management, its board, its shareholders and other stakeholders (OECD, Principles of Corporate Governance, revised May 2004). 2 The following url entered as of March-26-2014; http://scholar.google.com/scholar?q=%22corporate+governance%22&btnG=&hl=en&as_sdt=1%2C5&as_vis=1 http://scholar.google.com/scholar?q=%22Board+of+directors%22&btnG=&hl=en&as_sdt=1%2C5&as_vis=1 1 verify what the agent is actually doing (Jensen and Meckling 1976; Fama and Jensen 1983; Eisenhardt 1989). 3 Therefore, some form of corporate governance is necessary to oversee management activities and a strong and effective corporate governance mechanism would help protect the interests of the stakeholders against agency conflicts (Eisenhardt 1989; Baysinger and Hoskisson 1990). Brown et al. (2011) provide a review of the current state of the corporate governance literature from the accounting and finance perspectives. In providing their review, the authors voice concerns over the apparent lack of theory being applied in examining corporate governance indices. Larcker et al. (2007) also express concerns regarding the lack of welldeveloped theory surrounding the complex and multi-dimensional nature of corporate governance. Using empirical archival data, they use exploratory principal component analysis to suggest that there are 14 dimensions one can use to measure corporate governance effectiveness. They caution, however, that these 14 indices are only an initial step in the process of developing indicators for corporate governance effectiveness. The massive financial frauds committed by, among others, Enron, Madoff, Olympus, Parmalat, Satyam, and WorldCom, have resulted in hundreds of billions of dollars in losses to the global economy (Brickey 2003; Anand 2009). In addition, we have recently witnessed a global financial crisis, which resulted in trillions of dollars in losses to society and threatened the very existence of the financial markets, financial institutions and in some instances, national governments (Claessens et al. 2010; Helleiner 2011). One of the primary catalysts associated with these harmful events is a lack of adequate monitoring, guidance and oversight of 3 For example, management may misrepresent financial performance of the company to show that they met market expectations while at the same time indicate to shareholders that they achieved the results required to receive their bonuses. Also, it is assumed that owners/investors/stakeholders are not knowledgeable about the companies' operations and also cannot be physically present to monitor and control management activities on a day-to-day basis (Ross 1973). 2 management's often aggressive and self-serving decisions. When properly designed and implemented, corporate governance can be an assurance mechanism that restores stakeholders' trust in corporations (Hilb 2012). There are several components of corporate governance both internal and external to the company. Internal components of corporate governance may include the board of directors and its committees (e.g., the audit committee, the compensation committee, the nominating and governance committee, etc.), corporate legal departments, and the internal audit function. 4 Meanwhile, external components of corporate governance include external auditors, monitoring by creditors, as well as regulators. In addition, there are recent examples of regulatory pronouncements in the U.S. pushing for better corporate governance implementations, including Regulation Fair Disclosure of SEC (2000), Sarbanes-Oxley Act (2002), the creation of the PCAOB (2002), and the Dodd-Frank Wall Street Reform and Consumer Protection Act (20112012). It is generally expected that a strong and effective system of corporate governance will protect the interest of stakeholders and prevent corporate wrongdoings. This raises the question as to what structure and attributes constitute an effective system of corporate governance. As corporate governance is a large and diverse field, any attempt to address all of the various attributes and components of the subject is well beyond the scope of any one paper. Therefore, we focus our efforts on investigating the structure and attributes that beget an effective board of directors, which constitutes an important internal component of overall corporate governance. 4 Board committees, such as the audit committee and compensation committee, among others, are comprised of a subsample of board members, drawn from the full board. As a result, the characteristics of and influences on subcommittees are reflective of the characteristics of and influences on the company's full board. Thus, while the full board is the focus of the model we present, the same model is applicable to the various sub-committees of the board, with one caveat. When modeling committees required by law to be comprised solely of full independent board members (e.g., the audit committee of public companies in the U.S.) the construct of independence should be considered to be met, i.e., true, unless there is direct and confirmable knowledge that the committee in question is in violation of the independence requirement. 3 Independence, diligence, and competency of corporate board members have been emphasized as key attributes to evaluate when assessing performance of the board (e.g., NACD 1996; Carcello et al. 2002). Academics (e.g., Finkelstein and Mooney 2003; Huse 2005; Roberts et al. 2005) additionally suggest that characteristics pertaining to actual inner-workings within the board as well as directors' behavioral disposition and professional relationships with each other determine board effectiveness.5 Using the Bayesian framework, which has been used by a number of theoretical academic studies (e.g., see Stewart and Kinney 2013; Srivastava et al. 2012), we first model the effectiveness of the BOD as determined by four factors, which include independence from management, competence, level of activity (or diligence), and appropriate behavior inside the boardroom and between directors. Extant academic research examines some or all of these four factors as attributes to an effective board, but lack theoretical discussion as to the interrelationships among these factors. That is, how should these four factors be related to the effectiveness of the BOD? In our analytical model, we argue for a logical \"And\" relationship among these four attributes with the effectiveness of the BOD. We demonstrate that the BOD is most effective if and only if the directors are independent, competent, active, and display appropriate behavioral attributes. If any one factor is absent or any two or any three or all the four factors are absent then the BOD will be less effective. Furthermore, we introduce the concept of safeguards (controls) within the board of directors as an important component to our board effectiveness framework. This concept refers to mechanisms (both internal and external to the firm) that regulate and monitor board actions as well as directors' level of attentiveness to safeguard against board conduct that can threaten their 5 Roberts et al. (2005) observe that research on corporate governance and board of directors lacks understanding of the behavioral processes within boards of directors and have not fully considered such factors in evaluating board effectiveness. 4 reputational capital, heighten potential litigation liabilities, and violate regulatory provisions or rules of conduct.6 We note that the effectiveness of safeguards can and often does vary from one board to another, as some directors may be less concerned about risks to reputation capital, litigation risk, and regulatory enforcement than other directors. In our framework, safeguards function as a direct control to board effectiveness, because the degree of safeguards against conduct that violates fiduciary duties has a direct impact on each of the four constructs (i.e., independence, competence, activity, and behavior attributes). Ultimately, boards are most effective when a high level of safeguards accompany a strong presence of board independence, competence, activity, and appropriate behavioral attributes. The paper contributes to the extant literature on corporate governance by developing a theoretical framework defining an effective BOD. We answer the calls for research to advance formal theoretical work on corporate governance and the BOD (Larcker et al. 2007; Brown et al. 2011). For example, Larcker et al. (2007, pp. 996) note that \"without a well specified underlying structural model linking the many dimensions of governance to firm level decision making and overall firm performance, it is difficult to make strong conclusions about the importance of corporate governance.\"7 The results of our analysis reveal that modeling the \"And\" relationship is essential for assessing the effectiveness of the BOD function. Finally, because the influence of corporate governance (and specifically BOD effectiveness) on corporate outcomes is of importance to all stakeholders, our study should be of interest to regulators, auditors, executives, directors, and investors. Corporate scandals involving 6 An example of a safeguard is the board's attentiveness to complying with certain legal provisions that hold members of the board of directors responsible and punishable by jail and fines if they were found negligent in fulfilling their responsibilities. 7 Larcker et al. (2007) further state that future research is needed to refine measures of corporate governance and develop structural models to enable a more sophisticated examination of the importance of corporate governance mechanisms. 5 Tyco International Ltd., Comverse Technology, Inc., McAfee, Inc., and Enron Corporation have brought about increased scrutiny on the BOD in promoting and protecting shareholders' interests. Furthermore, the role and responsibilities of the BOD is highlighted in recent U.S. regulatory provisions, including SOX, PCAOB auditing standards, and the Dodd-Frank Act. We bring attention to the need for stakeholders to evaluate BOD effectiveness based on the interrelationships of the four attributes examined in this study. 2. Attributes of an Effective Board of Directors The principles of agency theory imply that agents (i.e., management) may be reluctant to impose strict and binding mechanisms of corporate governance that may limit the agents' ability to act in their own best interest (Ross 1973; Eisenhardt 1989). As a result, there arises a need for stakeholders to have an entity on the inside to play a role in governing and monitoring the firm's actions on the stakeholder's behalf - i.e., the board of directors (Baysinger and Butler 1985; Hillman and Dalziel 2003; Xie et al. 2003). Prior research establishes that boards face a dual set of responsibilities which can, and do, compete with one another to serve as the board's primary area of focus. In particular, companies elect a board in order to provide operating guidance to the firm's management team and/or serve as a monitoring mechanism over firm management (e.g., Boone et al. 2007; Baldenius et al. 2014; Kim et al. 2014). The board of director constructs we describe, and employ throughout this paper are relevant to boards focusing on either monitoring management or providing guidance to management. Boards do not treat these two objectives as being mutually exclusive (Kim et al. 2014), nor is there a \"one-size fits all\" model applicable to all boards (Coles et al. 2008; Wintoki 2007). As a result, there is clearly overlap in the characteristics of importance to both the monitoring and the guidance functions. Thus, the same basic characteristics are of significant 6 importance regardless of the board's primary focus (Coles et al. 2008; Cicero et al. 2013; Kim et al. 2014). Prior corporate governance research (e.g., Gompers et al. 2003; Deutsch 2005; Brown et al. 2011; Roberts 2012) suggests that efficacy of the board of directors can be influenced by certain characteristics, including independence (I) of the board members from management, competence (C) or expertise of the board members (e.g., knowledge about business processes within the firm, particular fields (accounting, law, etc.), industry expertise, etc.), active (A) board members (i.e., the members meet frequently with the CEO and CFO to monitor their activities and advise, members diligent in attending board meetings and being active in those meetings), and appropriate behavioral attributes (B) by directors to act cohesively and constructively. We discuss each of these four attributes in turn. Independence of Board Members Prior studies suggest that more independent boards act in the best interest of shareholders and have stronger incentives to prevent and detect opportunistic behavior by management (Fama and Jensen 1983; Beasley 1996; Cotter et al. 1997). Between 1950 and 2005, Gordon (2007) reports that the composition of large public company boards has shifted from approximately 20% to 75% independent. He suggests that such dramatic increase is due to the increasing importance of shareholder value as the primary corporate objective and the greater informativeness of stock prices. He further notes that when the company commits to a shareholder maximizing strategy, independent directors are more valuable than insiders. To enhance the corporate governance of publicly traded companies, the Sarbanes-Oxley Act of 2002 and major U.S. stock exchanges have promoted and imposed requirements for board independence (Public Law 107-204; Chhaochharia and Grinstein 2007). For example, section 7 301 of SOX requires that each member of the audit committee be independent. The rule changes adopted by the NYSE and NASDAQ require firms to have a majority of independent board members and entirely independent compensation and nominating/governance committees (Engel et al. 2005; Linck et al. 2008). In a recent study, Linck et al. (2008) find that board of directors during the post-SOX period are more independent and more likely to separate the two posts of CEO and chairman of the board. Boone et al. (2007) examine changes in board structure as firms age from IPO to 10 years of age. They find that as a firm ages and grows in size; the board takes on more of a monitoring role as evidenced by firms adding independent board members, as well as firms increasing board size. However, they also find that boards of growing firms add independent board members in order to tap into outside expertise as the firm moves into new regions or diversified service offerings. A number of other studies document the value of having independent directors. For example, Beasley (1996) finds that the inclusion of larger proportions of outside members on the board of directors reduces the likelihood of financial statement fraud.8 Klein (2002) shows a negative relation between board independence and abnormal accruals. Further, she finds significant increases in abnormal accruals accompany reductions in board or audit committee independence. Using a sample of firms in the United Kingdom, Peasnell et al. (2005) find the likelihood of managers making income-increasing abnormal accruals, to avoid reporting losses and earnings reductions, is negatively related to the proportion of outsiders on the board. In addition, Anderson et al. (2004) find that board and audit committee independence are associated with lower cost of debt financing, indicating that creditors place importance on 8 Examining a sample of U.S. firms from 1978 to 2001, Uzun et al. (2004) find that firms with more independent boards, and board sub-committees are associated with lower levels of corporate fraud. 8 director independence in monitoring financial accounting reports. More recently, Knyazeva et al. (2013) show that proximity to larger pools of local director talent leads to more independent boards. Using the local pool of potential directors as an instrument for determining board independence, they find that board independence has a positive effect on firm value, operating performance, fraction of CEO incentive-based pay, and CEO turnover. In sum, prior work largely supports the notion that independence is an element that constitutes an effective board. Activity of Board Members As we contend above, the board's effectiveness depends on an \"And\" relationship between each of our four board constructs. The second construct that we examine is the activity level of the board of directors. As noted by Carcello et al. (2002, p. 371), the activity or diligence of the board consists of \"factors such as the number of board meetings and the behavior of individual board members surrounding such meetings (e.g., preparation before meetings, attentiveness and participation during meetings, and post-meeting follow-up).\" Regulators and academics largely support the proposition that high activity level and diligence in completing board duties increase board effectiveness (Lipton and Lorsch 1992; Vafeas 1999; Carcello et al. 2002). The Blue Ribbon Committee, for example, advocates that the audit committee of the board can provide better assurance over the quality of the financial statements by having at least 4 meetings a year (Anderson et al. 2004). The vast majority of academic empirical work measure board activity and diligence by the number of board meetings, finding associations between such measure and economic outcomes. For example, Vafeas (1999) finds that share price declines are followed by higher meeting frequencies and years with an abnormally high meeting frequency are followed by improvements in operating performance. MacAvoy and Millstein (1999) find boards that meet 9 frequently help companies produce higher rates of return for their shareholders, as measured by earnings in excess of cost of capital and net of the industry average. Furthermore, Anderson et al. (2004) find evidence suggesting that audit committee activity is quite important to creditors. Specifically, their findings reveal that firms with more audit committee meetings are associated with a significantly lower cost of debt financing. A stream of research also associates board meeting frequency with better monitoring effectiveness. For example, Carcello et al. (2002) find that diligent boards promote shareholder interests by purchasing differentially higher-quality audit services. In addition, Xie et al. (2003) document that board and audit committee meeting frequencies are associated with reduced levels of earnings management. Competence of Board Members The third board effectiveness construct is competence or ability of the board. Even if the mix of independent-to-non independent board members is ideal and these board members are actively engaged in performing their duties, if the board does not contain individuals properly qualified to provide guidance and monitoring to management, the board will ultimately be ineffective. Some have argued that directors who hold multiple directorships have made a significant investment in developing their reputation capital as competent directors (e.g., Fama and Jensen 1983; Carcello et al. 2002; Abbott et al. 2003). Ferris et al. (2003) note that firm performance, during a director's tenure, has a positive effect on the number of board seats a director subsequently obtains, thus suggesting that reputation matters in the market for directors. In addition, some studies document benefits to multiple directorships. For example, Cotter et al. (1997) document that boards having directors holding multiple directorships are able to obtain 10 larger premiums in tender offers for their shareholders. Carcello et al. (2002) find that boards where multiple directorships are common are more likely to protect shareholder interests and purchase differentially higher-quality audit services.9 Regulatory provisions and prior academic work also associate competence with expertise or knowledge held by directors. For example, the SEC acknowledges the importance of financial expertise on the audit committee and requires companies to disclose whether it has at least one \"audit committee financial expert\" serving on its audit committee. In this case, such an expert has characteristics that are particularly relevant to the functions of the audit committee, such as: a thorough understanding of the audit committee's oversight role, expertise in accounting matters as well as understanding of financial statements, and the ability to ask the right questions to determine whether the company's financial statements are complete and accurate (SEC 2003).10 Studies have documented value from having directors with specific expertise. Kroll et al. (2008) document that boards comprising of directors that are vigilant as well as having appropriate knowledge gained through experience are better monitors and more useful advisors to top managers. DeFond et al. (2005) find a positive market reaction to the appointment of accounting financial experts assigned to audit committees, suggesting that the market deems accounting-based financial skills to improve the audit committee's ability to ensure high-quality financial reporting. Other works also document the positive effects of having financial and legal 9 Ferris et al. (2003) test the hypothesis that directors who serve on multiple boards become so busy that they cannot monitor management adequately (i.e., the busyness hypothesis). Their results suggest that market participants do not view the appointment of a multiple director as a negative event for the firm; multiple directors actually sit on more committees and attend more meetings; no statistically significant evidence that firms with multiple directors are more vulnerable to securities fraud litigation. They conclude that the evidence does not support the proposition that multiple board memberships harm firm value. 10 Linck et al. (2008) find that, in the post-SOX period, board members are more likely to be lawyers, consultants, financial experts or retired executives. 11 experts on the audit committee on internal controls and financial reporting quality (e.g., Carcello et al. 2002; Krishnan 2005; Krishnan and Visvanathan 2008; Krishnan et al. 2011). More recently, Kim et al. (2014) suggest that a director's tenure with the firm is positively associated with the director's competency to advise and monitor firm performance. More specifically, they contend that \"longer director tenures reflect more board and committee meetings attended, likely increased committee assignments, greater experience with the firm's strategies and policies, and greater within-firm deal-level experience (Kim et al. 2004, p. 111).\" Consistent with their hypotheses, they find outside director tenure to be associated with better firm acquisition/investment policy advising performance, lower CEO rent extraction, and higher operating performance measures. Behavioral Attributes of Board Members The final construct necessary for board effectiveness is the behavioral attributes and relationships among directors. The board's behavioral attributes can be broadly defined as the ability of the board to act as a cohesive unit, allow for constructive suggestions among its members, work well together as a team, and foster a positive intra-working relationship among team members (Forbes and Milliken 1999; Finkelstein and Mooney 2003; Roberts 2012). Using in-depth interviews with company directors, Roberts et al. (2005) examine the behaviors and relationships of non-executive directors to evaluate board effectiveness. The authors suggest that while board structure, composition, and independence each play an important role, it is ultimately the actions and conduct by individual board members that determine board effectiveness. Specifically, they suggest that a variety of behaviors - challenging, questioning, probing, discussing, testing, informing, debating, exploring, encouraging - are crucial for directors to be effective. 12 Forbes and Milliken (1999) integrate research on workgroup effectiveness with research on the board of directors. They identify group cohesiveness (agreement on the common goals of the board) along with the degree to which task-oriented disagreement (constructive criticism of another's idea) is permissible among board members, as necessary elements in assessing board effectiveness. Furthermore, Finkelstein and Mooney (2003) identify five interrelated board behavioral processes that can make boards more effective - engage in constructive conflict, avoid destructive conflict, work together as a team, know the appropriate level of strategic involvement, and address decisions comprehensively.11 Finally, Roberts et al. (2005) advance three linked sets of behaviors that suggest directors should be 'engaged but non-executive', 'challenging but supportive' and 'independent but involved.' Safeguards within the Board of Directors Directors are attentive to protecting their reputational capital (Fama and Jensen 1983; Gilson 1990). Indeed, prior academic work informs that directors who are associated with corporate catastrophes and fail to exercise reasonable care in fulfilling their responsibilities are often subject to labor market penalties (Fama 1980; Gilson 1990; Carcello et al. 2002). Srinivasan (2005), for example, finds that director (especially audit committee) turnover is higher for firms that restate their earnings (i.e., overstated their earnings) compared to nonrestating firms.12 Fich and Shivdasani (2007) investigate the reputational impact of financial fraud for outside directors, finding that directors of sued fraud-committing firms experience a significant decline in board seats held at other companies. 11 Please see Appendix B for more information about Finkelstein and Mooney (2003) five board behavioral processes. 12 Srinivasan (2005) also documents that directors of firms with overstated earnings are no longer present in 25% of their positions on other boards. 13 Directors are also attentive to avoiding or minimizing legal liability (Gilson 1990; Kesner and Johnson 1990; Carcello et al. 2002). Recent lawsuits against directors of companies such as Target, Groupon, and News Corp. highlight examples of current cases where directors are targets of shareholder lawsuits. As suggested by Brochet and Srinivasan (2013), directors named as defendants in securities lawsuits face the possibility of financial and reputational harm, lost time and emotional distress. Brochet and Srinivasan (2013) also show that directors named in lawsuits receive more negative recommendations from the proxy advisory firm and attain significantly more negative shareholder votes than directors in a benchmark sample. Furthermore, directors are often wary of conducting improprieties that may cause predicaments with regulatory authorities (i.e., SEC, IRS, etc.). Section 305 of the Sarbanes-Oxley Act, for example, states that the SEC may issue an order to prohibit any person from acting as a director of an issuer if the SEC has found that such person's conduct \"demonstrates unfitness\" to serve as a director of any such issuer (Marden and Edwards 2005). We contend that safeguards greatly influence board effectiveness. Our concept of safeguards pertains to the strength of mechanisms that regulate and oversee the board's conduct. The mechanisms include numerous factors, such as the company's own disciplining procedures for board misconduct; extensiveness of corporate bylaws and code of ethics; monitoring over the board by shareholders, institutional investors, and analysts; penalties in the labor market for directors; professionalism guidelines, board evaluations; as well as industry-specific and/or market-wide regulations. Safeguards can also reflect individual director's (and the overall board's) proclivity to guard against actions and decisions that can jeopardize reputational capital, heighten litigation risk, and violate regulatory provisions or rules of conduct. We treat this construct of safeguards as a direct control to board effectiveness, because the level of safeguards 14 has a direct impact on each of the other four constructs (i.e., independence, competence, activity, and behavior attributes). We maintain that the level of safeguards can vary from one board (or individual director) to another. While all directors should ideally be concerned about their reputation capital, litigation risk, and compliance with regulatory provisions, it is likely some directors are less alarmed by such issues than others. Based on a sample of securities class-action lawsuits from 1996 to 2010, Brochet and Srinivasan (2013) show that only a minority of independent directors have actually been named as defendants. Black et al. (2006) argue that litigation risk for directors may be exaggerated and report that outside directors of U.S. public companies who fail to meet their fiduciary duties almost never face personal liability losses because of such factors as directors and officers (D&O) liability insurance. Furthermore, in a N.Y. Times article titled \"Ex-Directors of Failed Firms Have Little to Fear,\" Davidoff (2011) suggests that former directors of Enron have recovered nicely from the scandal and that former directors of failed institutions during the financial crisis do not have much to worry about. In the following sections, we present both a structure and a set of basic attributes that define effective board of directors. The basic attributes have been obtained from the research domains mentioned above. We provide a logical argument based on Bayesian reasoning to relate these attributes to the overall effectiveness of the board. 3. Bayesian Model for the Effectiveness of Board of Directors In this section we develop a theoretical model for the effectiveness of board of directors (BOD) under the Bayesian framework in terms of the basic attributes of board effectiveness. We use the Mautz and Sharaf (1961) philosophical approach to determine the basic attributes of BOD and their relationship to BOD effectiveness. As established by several researchers (e.g., 15 Brown et al. 2011; Gompers et al. 2003; and Roberts 2012) and as discussed in the previous sections, the board of directors effectiveness is determined, basically, by several characteristics (attributes) such as Independence (I) of the board members from the management, Competence (C) of the board members in firm-specific knowledge, particular fields of expertise (e.g., accounting, finance, law, etc.), and the specific industry in which the firm operates, Active (A) board members (i.e., the members meet frequently with the CEO and CFO to monitor their activities and advise, members are diligent in attending board meetings and being active in those meetings), and the board members possess appropriate behavioral attributes (B) to act cohesively and constructively as a team player.13 As discussed in Section 2, we consider an additional construct \"safeguards\" for the effectiveness of BOD. We argue that the construct \"safeguards\" is not a basic attribute of the BOD members to make it effective rather it is a control mechanism to governing the basic attributes of the BOD members. Some examples of \"safeguards\" such as legal liability against BOD members and reputation loss of BOD members of companies that are involved in fraudulent behavior are discussed in Section 2. The current literature on the characteristics of an effective BOD simply identifies the above attributes (Independence, I; Competence, C; Active members, A; and Behavioral attributes, B) without providing any insights into their interrelationships. Given that most of the factors have been identified through linear regression models, the effectiveness of BOD is measured through a simple linear model of independent variables, I, C, A, and B, without any theoretical discussion as to the interrelationships among these variables. In fact, Larker et al. (2007), and Brown et al. (2011), repeatedly criticize the current literature for its lack of theory in establishing the interrelationship among the basic attributes of an effective BOD. 13 See Table 1 for examples of characteristics that constitute each of the four board effectiveness attributes. 16 Empirical research finds that the following four factors are the basic attributes of an effective BOD: members of BOD must be independent (I), they must be competent (C), they must be Active (A), and must possess appropriate behavioral characteristics (B) to act cohesively and constructively as a team player to provide guidance and monitor the performance of the management. The question is how should these factors be related to the effectiveness of the BOD? As mentioned earlier, since the attributes are established through linear regression models, one would imply that the effectiveness of BOD is related to various attributes through a linear relationship. A linear relationship implies that one can substitute one attribute for another. However, when one tries to interpret the linear relationship logically it may not make sense. For example, consider the following situation where all the BOD members were independent, regularly met with the CEO and CFO to discuss the company's strategies, plans and activities, and had the appropriate behavioral characteristics, but were incompetent. Would this be an effective board? No, not at all! In fact, the BOD will not be effective if any one, any two, any three, or all the four of the attributes are absent. Thus, we argue for an \"And\" relationship among these attributes with the effectiveness of BOD. In other words, the BOD will be most effective only when all four attributes, I, C, A, and B, are present. That is, the BOD is most effective if and only if the BOD members are independent (I), competent (C), active (A), and the members possess appropriate behavioral characteristics (B). We analyze various scenarios in this section after developing the probabilistic model. It is important to point out that we employ a probability model because of the uncertainties involved in assessing whether certain attributes are present or absent. The \"And\" relationship can be expressed in terms of the following set notations: eb = icab, 17 where 'eb' represents the state that the BOD is effective, 'i' represents the state that BOD members are independent, 'c' represents the state that BOD members are competent, 'a' represents the state that BOD members are active, and 'b' represents the state that BOD members possess appropriate behavioral characteristics. In terms of the negations of the above states, one can write the above relationship as an \"Or\" relationship: ~eb = (~icab)(i~cab)(ic~ab)(ica~b)(~i~cab) (~ic~ab)(~ica~b)(i~c~ab)(i~ca~b)(ic~a~b) (~i~c~ab)(~i~ca~b)(~ic~a~b)(i~c~a~b)(~i~c~a~b). The above equation implies that the BOD will be ineffective (~eb) if any one, any two, any three, or all the four of the attributes are absent. In the present discussion, we have assumed all the attributes to be binary variables. Thus, we want to develop a formula for the posterior probability that BOD is effective given that we have information about the four attributes, I, C, A, and B, whether they are present or absent. Similar arguments are common in audit and information systems literature. For example, the audit literature argues that an account is fairly stated if and only if all its management assertions such as Existence, Completeness, Valuation, Rights and Obligation, etc. are true (see AICPA's SAS 106, 2006). In developing a fraud risk assessment formula, Srivastava et al. (2007) have used the \"And\" relationship among the fraud triangle factors, Incentives to benefit from fraud, Attitude to commit fraud, and Opportunity to commit fraud, with the commitment of fraud by management. All the three fraud factors have to be present for management to commit fraud. Desai et al. (2010) have used similar arguments in determining the strength of the internal audit function. They argue that the internal audit function will be strong if and only if the internal auditors are competent, they are objective, and their work is of high quality. ----- Figure 1 about here ----Figure 1 depicts an evidential diagram (Srivastava 2011) for the problem at hand. The 18 main assertion that BOD is effective is related to four attributes (i.e., constructs) through the \"And\" relationship. In general, they are known as variables. These variables are assumed to be binary and are represented by rounded boxes. The rectangular boxes in Figure 1 represent items of evidence pertaining to the variables they are connected to. We have derived a general formula, Equation (A9), in Appendix A, for the posterior probability of the main variable being true as a function of the strength of evidence pertaining to the main assertion and each sub-assertion expressed in terms of the likelihood ratio, , and the corresponding prior odds, O. In the case of BOD, we have five variables, the main assertion, EB, representing the effectiveness of BOD with two values {eb, ~eb}; 'eb' representing \"effective BOD\" and '~eb' representing \"ineffective BOD\