Who Monitors the Monitor? The Effect of Board Independence on Executive Compensation and Firm Value Praveen Kumar and K. Sivaramakrishnan University of Houston Recent corporate governance reforms focus on the board’s independence and encourage equity ownership by directors. We analyze the efficacy of these reforms in a model in which both adverse selection and moral hazard exist at the level of the firm’s management. Dele- gating governance to the board improves monitoring but creates another agency problem because directors themselves avoid effort and are dependent on the CEO. We show that as directors become less dependent on the CEO, their monitoring efficiency may decrease even as they improve the incentive efficiency of executive compensation contracts. Therefore, a board composed of directors that are more independent may actually perform worse. Moreover, higher equity incentives for the board may increase equity-based compensation awards to management. (JEL G31, G34, D82) The performance of corporate boards has come under scrutiny in recent years, following a wave of corporate scandals. There is major concern that CEOs wield an inordinate influence on the board’s constitution and functioning and that directors are excessively dependent on the management (e.g., Crystal, 1991; Bebchuk and Fried, 2004; and Morgensen, 2005). Indeed, regulatory bodies such as the SEC, along with the NYSE and the NASDAQ, have instituted a number of reforms to promote the board’s independence. Both the NYSE and the NASDAQ now require that a majority of directors on corporate boards should be independent, and that only independent directors should serve on the audit and compensation subcommittees. 1 At the same time, there is a notable We thank the editor, Bob McDonald, and an anonymous referee for very helpful comments. We also thank Sandeep Baglia, Bala Balchandran, Joel Demski, Douglas Gale, Ed Green, Steve Huddart, Kose John, Sok-Hyon Kang, Paul MacAvoy, Todd Milbourn, Dilip Mookherjee, John O’Brien, Madhav Rajan, Stefan Reichelstein, Susan Spring, Shyam Sunder, Jean Tirole, Donna Zerwitz, and participants at the 2003 Summer Econometric Society meetings and the 2004 CMU Accounting Conference for comments and discussions on issues addressed in the paper. Address correspondence to Praveen Kumar, University of Houston, C.T. Bauer College of Business, Houston, TX 77204-2016; telephone: (713) 743-4770; fax: (713) 743-4789; e-mail: pkumar@uh.edu 1 While the board’s independence fundamentally relates to the extent to which directors’ interests are aligned with the interests of the CEO, these governance reforms define the board’s independence from the viewpoint of verifiability. For example, the New York Stock Exchange Listing Standards define a director’s independence as the absence of material connection with the firm—either directly or as a partner, shareholder, or officer of an organization that has a relationship with the company (see, e.g., Bainbridge, 2002). C  The Author 2008. Published by Oxford University Press on behalf of the Society for Financial Studies. All rights reserved. For permissions, please e-mail: journals.permissions@oxfordjournals.org. doi:10.1093/rfs/hhn010 RFS Advance Access published March 3, 2008