Boards of Directors as an Endogenously

Determined Institution

Benjamin E. HermalinMichael S. Weisbach

Presented by: Michael KeefeJanuary 18, 2006

FIN 7340 Corporate Theory II Dr. Nina Baranchuk

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“The directors of [joint stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance [as owners]....Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company”

Adam Smith -1776

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Key Questions

How do board characteristics or size affect profitability?

How do board characteristics affect observable actions of the board?

What factors affect the makeup of boards and how do they evolve over time?

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Introduction – Survey Paper

Definition – An economic institution that, in theory, helps to solve agency problems inherent in managing an organization.

Formal theories limited Major Conflict – Between CEO and Board Significant empirical work, but little motivated

by theory

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Empirical Regularities

Composition (insider/outsider ratio) does not imply profitability

Number of directors is inversely related to performance

Board actions are related to board decisions( insider/outsider ration is related toPoison Pills, Acquisitions, Compensation)

Boards evolve relative to bargaining position of CEO

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Why are there boards? Regulation Driven –

Boards pre-date regulations Larger than required by law

Hypothesis Market solution to an agency problem Endogenously determined institution

Provides contracts and incentives to management Shleifer and Vishny (1986) – Free-Rider problem

alleviated by large outside shareholder. Power of shareholder works through board.

Meissner (2000) – Side payments greater than gains for bad loans.

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What do they do?

Outside Director as a Monitor Fama (1980), Fama and Jensen(1983) – build reputation

as expert monitor Kaplan and Reishus (1990) – build reputation as doesn’t

make trouble Hermalin and Weisbach (1998) Board Specific

Model Board decides to keep or fire CEO CEO ability linked to performance CEO prefers less independent board CEO bargaining power related to performance

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Hermalin and Weisbach Predictions

1* Poor performance=>increase probability of replacement2* Board independence => higher CEO turnover3* Poor performance => more independent directors4* CEO tenure=>less board independence5* Accounting measures better predictor of tenure than stock

performance6 Long Term persistence in corporate governance7 CEO fired

Private information => negative return Public Information => positive return

8 CEO Salary Low Levels of Performance => limited affect to salary High Levels of Performance => affects salary

* Strong empirical support

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Empirical Issues

System Actionst+s= φCharacteristics + ε

Profitst+s = βActions + η

Characterisitcst+s = μProfits + ξ

Equilibrium or Out-of-Equilibrium? Methods

Typically not jointly estimated Endogeneity handled with lags

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Tobin's q Tobin's q = market value / asset value

If the market value = asset value => Tobin's q= 1.0. If Tobin's q > 1.0, then market value > than the

value of the company's recorded assets. Tobin's q reflects a number of variables, and in

particular: The recorded assets of the company. Market sentiment, reflecting, for example, analysts' views

of the prospects for the company, or speculation such as bid rumors.

The intellectual capital of the company.

Source: Wikepedia

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Outside Directors and Performance Method: Contemporaneous Correlations with accounting measures

and Tobin q Results: No Evidence supporting outside directors and performance

Issue: Endogeneity – Poor performance leads to independent boards (Hermalin and Weisbach 1998)

Method1: Lagged Performance as instrument for current performance Results1: No Evidence supporting outside directors and performance

Method2: Rosenstein and Wyatt (1990) use event study for outside directors added to board

Result2: Some evidence - .2% increase in return Benefit of Method: Controls for all firm specific effects

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Board Size and Performance

Jensen (1993) and Lipton and Lorsch (1992) suggest increase board size leads to agency problems

Yermack (1996) – Negative Relation between board size and Tobin’s q

Gertner and Kaplan (1996) Study: Board sizes of reverse leverage buyouts Method:board size smaller than comparable firm

Equilibrium or out of equilibrium – Why hasn’t economic darwinism eliminated the unfit organizational form?

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Board Size and Tasks (actions as a function of characteristics)

CEO Turnover Findings: Robust relationship between turnover and performance Empirical issue – voluntary or non-voluntary

Weisbach (1988)- Approach: interacts board composition with firm performance Finding: CEO turnover more sensitive to firm performance with

outside directors. Robust to performance as measured by accounting or market

measures CEO turnover with insider dominated boards not performance

sensitive Yermack (1996) and Wu (2000) – Interact board size with

performance and find smaller boards are more effective overseers of CEOs.

Perry (2000) – Incentive pay also significant

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Evidence from Takeover Market Shivdasani (1993) –

Question: probability of takeover in a hostile bid? Finding: Additional directorships => lower probability Why?

Cotter et al. (1997) Question: Relationship between return from hostile takeover and outside

directors Result: Majority of outside directors=>20% increase in return.

Harford (2000) – Documents pecunary interests of directors to resist a takeover.

Byrd and Hickman (1992) Question: Relationship between return when acquiring Results:

-1.33% abnormal return for entire sample -.07% abnormal return if 50% of directors outside -1.86% abnormal return if minority of directors outside

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Poison Pills

Effect can be argued both ways: Protect Management Increase bargaining position

Brickley et al. (1994) Method: Split sample, analyzed market reaction Results: Poison Pill Announcements=>

Decrease in price if majority inside directors Increase in price if majority of outside directors

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Executive Compensation

Core et al. (1999) Results: Weaker goverance => Higher CEO pay Measures:

Outsiders appointed by CEO Directors over 69 Board Size Busy Directors (additional directorships) Interlocking Directors

Yermack (1996) – pay for performance increases with small boards

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Board Dynamics

Changes in a firm’s characteristics =>changes in board composition

Hermalin and Weisbach (1988) Poor Performance => more outside directors CEO succession imminent => more inside

directors Firm leaves a product market => inside directors

depart

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CEO Power Struggle with Board

Fundamentally Unobservable Approaches

Hallock (1997 1999) - Interlocking directorships Shivdasani and Yermack (1999) – board selection

process (e.g. seperate nominating commitee) Baker and Gompers (2000) – CEO voting stake

=> board selection in IPO

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Industry Studies

Hospitals – non-profits and for-profit hospitals Brickley and Van Horn (2000) – can’t reject

that both types maximize the same objective function

Eldenberg et al. (2000) – find sensitivity to CEO turnover related to hospital performance, high admin costs, and high levels of uncompensated care vary by hospital type.

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Future Research Directions

Model inner workings of boards Test implications of models Study different type of boards – nonprofits,

smaller firms, etc.