Final answer:
Board composition ensures that a firm serves its shareholders' interests, with a balance between inside directors, familiar with company operations, and outside directors, who provide objective oversight. The strong influence of top executives in board selection raises potential conflicts, underscoring the importance of governance institutions.
Step-by-step explanation:
Board composition is a critical element of corporate governance as it helps to ensure that a firm is run in the interests of its true owners - the shareholders. The composition of the board is significant because it strikes a balance between 'inside' directors, who are often part of the company's management and have detailed knowledge of its day-to-day operations, and 'outside' directors, who are independent of the company and can provide unbiased oversight and unique perspectives. The tradeoff involves potential conflicts of interest with insiders and the need for corporate oversight by outsiders.
Top executives who run the firm have a strong voice in choosing which candidates will be on their board of directors. This can create issues, as few shareholders have the resources to nominate alternative members. There are several institutions of corporate governance, including the board of directors, auditing firms, and outside investors, which are meant to provide oversight. However, failures in corporate governance, such as in the case of Lehman Brothers, highlight the importance of having an effective and well-composed board.