Director independence as strategic behavior

This paper analyzes the independence of boards of directors as an optimally chosen, non-contractible behavior. A board behaves loyally to a CEO when it agrees to a negative NPV-pro ject, giving the CEO private benefits. While the CEO benefitsfrom competent directors because they help him make better decisions, the analysis reveals that loyalty is endogenously easier to obtain from a less competent board. Themodel implies that shareholders face a tradeoff between higher CEO pay and more inefficient board loyalty. It also holds predictions for how firm characteristics, other corporate governance features, and the business environment affect endogenous board competence.