corporate governance
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Corporate GovernancePresentation Good governanceTRANSCRIPT
Short-Term FinancingInternational Corporate Governance
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Lecture Aims
This lecture reviews the main devices or mechanisms that are believed to ensure that managers run the firm in the interests of the shareholders and punish badly performing managers. The lecture assesses the effectiveness and importance of these mechanisms across various corporate governance systems. It covers among others the following mechanisms: the market for corporate control and hostile takeovers, dividend policy, the board of directors, institutional shareholders, shareholder activism, managerial compensation, managerial ownership, monitoring by large shareholders and creditors/banks.
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Learning Outcomes
By the end of this lecture, you should be able to:
Assess the importance of various corporate governance devices across the main systems of corporate governance
Judge the efficiency of the various devices in terms of preventing bad performance by the management and/or disciplining bad managers
Critically evaluate the empirical research on the importance and effectiveness of corporate governance devices
Identify the gaps in the existing literature.
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Corporate governance devices or mechanisms are arrangements that mitigate conflicts of interests corporations may face.
These conflicts of interests are those that may arise between
the providers of finance and managers,
the shareholders and the stakeholders, and
different types of shareholders (mainly the large shareholder and the minority shareholders).
Introduction
5.*
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
Particular corporate governance mechanisms are more likely to prevail in one corporate governance system than in others.
The reason is that the prevalence of the above conflicts of interests is also likely to vary across systems.
Hence, in order to study the effectiveness of the various corporate governance devices, one needs to adopt one of the taxonomies of corporate governance systems.
Introduction (Continued)
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
We adopt the taxonomy by Julian Franks and Colin Mayer which distinguishes between insider and outsider systems.
We adopt this taxonomy for two reasons
It does not advocate the superiority of one system
It provides a broad, yet convenient framework to analyse the various corporate governance devices.
Introduction (Continued)
Product Market Competition
Competition in product and service markets may reduce managerial slack across all corporate governance systems.
For example, a French manufacturer of household appliances operates in the same global market as manufacturers from other countries.
If the French manufacturer suffers from weak corporate governance, it may ultimately be driven out of the market.
5.*
Product Market Competition (Continued)
Benjamin Hermalin has developed a theoretical model about the effects of competition on managerial (agent) performance.
He argues that competition has four distinct effects on managerial performance
the income effect,
the risk-adjustment effect,
5.*
The income consists of the following
expected income decreases with increased competition,
but it also puts pressure on managers to perform better by e.g. reducing their perks as well as other costs.
The risk-adjustment effect concerns the fact that competition changes the riskiness of the various actions managers can take.
Product Market Competition (Continued)
The change-in-information effect consists of the following
Competition makes it easier for the principal to judge the agent’s actions as there is now a (larger) peer group of other companies
Competition also has an effect on managerial actions by reducing the riskiness of both easy and hard actions
However, the decrease in riskiness may not necessarily be uniform across both easy and hard actions
Hence, it is not clear whether managers will switch from easy to hard actions or the converse.
Product Market Competition (Continued)
Increased competition also changes the relative value of managerial actions
By reducing the price cap, competition reduces the agent’s expected income and hence his incentives to work hard
However, it also increases the value attached to cost saving actions by the agent, making the latter work harder.
A priori, all of the above four effects have ambiguous signs.
Hermalin shows that under certain conditions the positive income effect will dominate and competition will increase managerial performance.
Product Market Competition (Continued)
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
However, generally it is still not clear whether increased competition increases or decreases managerial performance.
While empirical evidence on the effect of competition is still sparse, the studies that exist suggest that
competition forces managers to work harder, and
it may even be a substitute for good corporate governance.
Product Market Competition (Continued)
Incentivising and Disciplining Managers
in the Insider and Outsider Systems
The main mechanisms that are thought to keep managers in check in the outsider system are
the market for corporate control (= hostile takeover?),
dividend policy,
*
- concentrated control and complex ownership structures,
- managers being monitored and disciplined by the large shareholder, and
- underdeveloped takeover and stock markets.
Outsider systems are characterised by
- dispersed ownership and control,
Slide 5.*
Incentivising and Disciplining Managers
In the insider system, they are
monitoring by large shareholders, and
monitoring by banks and other large creditors.
5.*
The Market for Corporate Control
The disciplinary role of the market for takeovers was first proposed by Henry Manne.
Badly performing firms see their share price drop.
They then become easy targets for hostile raiders intend on changing the management, thereby creating firm value.
However, the empirical evidence does not support Manne’s argument.
5.*
The Market for Corporate Control (Continued)
A US study by William Schwert and a UK study by Julian Franks and Colin Mayer investigate the pre-acquisition performance of targets of hostile takeovers and targets of friendly takeovers.
Hostility is defined as the target management’s attitude toward the proposed takeover bid.
Neither the US nor the UK study finds any difference in the pre-acquisition performance of both types of targets.
5.*
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
However, the mere threat of a hostile takeover may be enough to ensure that managers do not shirk.
Still, hostile takeovers are an extreme and expensive mechanism to correct managerial failure.
They also tend to be very rare outside the UK and the USA.
The Market for Corporate Control (Continued)
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Dividends and Dividend Policy
Frank Easterbrook and Michael Rozeff were the first to formalise the corporate governance role of dividends.
In Rozeff’s model, dividends reduce agency costs by reducing the free cash flow.
However, they also increase transaction costs as higher dividends increase the need for costly external financing.
Hence, there is an optimal dividend payout which minimises the sum of both costs.
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Dividends and Dividend Policy (Continued)
Easterbrook also argues that by committing to high dividends the free cash flow is kept to a minimum and wastage by the managers is reduced.
In addition, the firm has to raise regularly outside finance.
Each time it does so it subjects itself to the scrutiny of outsiders.
If the managers have been performing badly, then outside finance is unlikely to be made available.
5.*
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
For dividends to be able to fulfil their disciplinary role, they need to be sticky.
Managers will need to carry on paying dividends even if profits are down temporarily.
The role of dividends is likely to be more important in the outsider system given the lack of shareholder monitoring.
Dividends and Dividend Policy (Continued)
5.*
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
Marc Goergen, Luc Renneboog and Luis Correia da Silva study the flexibility of German dividends compared to UK and US dividends.
They find that, when profits are down temporarily, German firms are much more willing to cut or omit their dividends than UK and US firms.
German firms controlled by banks are even more willing to cut or omit their dividends.
They conclude that large shareholder monitoring acts as a substitute for dividends.
Dividends and Dividend Policy (Continued)
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Boards of Directors
UK and US firms as well as firms from most other countries have a single-tier board where both executive and non-executive directors sit.
A few countries, such as Germany and China, have two separate boards, the so called two-tier board.
The two-tier board consists of
the supervisory board where the non-executives (as well as maybe employee representatives) sit, and
the management board where the executives sit.
5.*
Boards of Directors (Continued)
There is an ongoing debate about whether a single- or two-tier board is better.
Some argue that having two boards ensures the independence of the non-executives from the executives.
Others argue that having two boards prevents the non-executives from being effective monitors due to a lack of information.
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Is there a link between board structure and financial performance?
Do boards fire executives in the wake of poor performance?
What factors determine board changes?
Should the roles of the chairman and the CEO be separated?
Boards of Directors (Continued)
Is There a Link between Board Structure
and Financial Performance?
The proportion of non-executives is normally used as a measure of board independence.
Boards that are dominated by non-executives are likely to be more independent from the management.
However, there is little evidence in support of a positive link between firm performance and board independence.
However, board composition may not be exogenous, i.e. it may not be randomly determined.
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Is There a Link between Board Structure
and Financial Performance? (Continued)
For example, board composition may be determined by past performance.
If poor performance causes an increase in the number of non-executives, then this would explain why no link has been found between firm performance and board independence.
In contrast, there is conclusive evidence that large boards are bad for firm performance.
There is also evidence that interlocked directorships cause collusion.
5.*
Do Boards Fire Executive Directors in
the Wake of Poor Performance?
There is consistent evidence of an increase in CEO and board turnover in the wake of poor performance.
There is such evidence for both corporate governance systems
the outsider system of the UK and the USA, as well as
the insider system of Germany and Japan.
However, board dismissals cannot be equated to good corporate governance.
Managerial dismissals also only occur in cases of extremely poor performance.
5.*
What Factors Determine Board Changes?
Benjamin Hermalin and Michael Weisbach find that
inside directors are more likely to be replaced by outside directors in poorly performing companies;
inside directors normally replace retiring CEOs;
when the CEO is replaced by an outsider, some inside directors – possibly the losers in the contest to the succession – leave the firm; and
firms leaving their product market replace their inside directors with outside directors.
5.*
What Factors Determine Board Changes?
(Continued)
Steven Kaplan and Bernadette Minton find that banks appoint representatives to the boards of poorly performing Japanese firms that are part of keiretsus.
5.*
Should the Roles of the Chairman and
CEO Be Separated?
There has been an ongoing debate as to whether the roles of the chairman and the CEO should be separated or whether duality is preferable.
Proponents of duality base themselves on the following three arguments
Duality ensures that there is strong leadership
Splitting the two roles may create tensions between the CEO and chairman
Having a separate CEO and chairman makes it difficult to designate a single spokesperson for the company.
5.*
Should the Roles of the Chairman and
CEO Be Separated? (Continued)
Those opposed to duality argue that
Combining the two roles reduces board independence and increase CEO entrenchment
It combines the role of monitoring the executives and leading the executives in a single person.
In the USA, minds are still split as to whether duality is good or bad.
The empirical evidence on US firms is also as yet inconclusive.
5.*
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
In contrast, in the UK successive codes of best practice in corporate governance have recommended the separation of the two roles.
In contrast to US evidence which is inconclusive, evidence from UK firms seems to suggest that duality has no effect on performance.
Should the Roles of the Chairman and
CEO Be Separated? (Continued)
Institutional Investors (Continued)
Institutional investors are the most important types of shareholders in the UK and the USA as well as a few other countries (e.g. the Netherlands).
However, the jury is still out as to whether institutional investors monitor the management of their investee firms.
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They reduce the levels of managerial pay.
Institutional Investors (Continued)
They reduce firm value
They have short-term horizons
Institutional Investors (Continued)
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
In the UK, successive codes of best practice in corporate governance have urged institutional investors to become more active.
The 2001 Myners Report states that
institutional investors “remain unnecessarily reluctant to take an activist stance in relation to corporate underperformance, even where this would be in their clients’ financial interests”.
A number of UK studies suggest that institutional investors are mostly passive and prefer exit over voice.
Institutional Investors (Continued)
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
Jana Fidrmuc, Marc Goergen and Luc Renneboog study the price reaction to insider trades in UK firms
They expect that monitoring reduces the information conveyed by insider trades.
They find that the price reaction
is highest for firms dominated by institutional investors, and
lowest for firms dominated by families and other firms.
They interpret this as evidence that institutional investors are passive.
Institutional Investors (Continued)
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
However, evidence from case study research by Marco Becht and others suggests that institutional investors act behind the scenes.
Still, from an agency perspective it is not clear why institutional investors should be the panacea (wondermiddel) to all corporate governance issues.
Institutional Investors (Continued)
Shareholder Activism
Shareholders may prefer to act behind the scenes to address poor managerial performance in their investee firms.
However, they may use so called proxy contests as a means of last resort if management remains unresponsive.
Proxy contests consist of soliciting the support of other shareholders, via their votes, to bring about change.
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Shareholder Activism (Continued)
While shareholder-initiated proxy voting is frequent in the USA and on the increase in the UK, it is relatively rare in Continental Europe.
Whereas proxy contests are relatively successful in the USA, they are less successful in the UK and Continental Europe.
Nevertheless, managers of US firms are not legally bound to implement shareholder proposals whereas they have to in the UK and most of Continental Europe.
5.*
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
The stock market reaction to proxy contests is also different between the USA and the UK-Continental Europe
In the USA, the stock price reaction is normally positive
In the UK and Continental Europe, it is negative suggesting that the market interprets proxy contests as a signal of shareholder discontent rather than positive change.
Shareholder Activism (Continued)
Managerial Compensation
One possible way of aligning the interests of the managers with those of the shareholders is managerial compensation.
By making managerial compensation sensitive to firm performance, managers should have the right incentives to maximise shareholder value.
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Managerial Compensation (Continued)
the base (or cash) compensation,
long-term incentive plans (LTIPs) such as stock options and restricted stock grants,
benefits, and
Figure 1 – Level and composition of CEO pay for 2005
Slide 5.*
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Is Managerial Compensation Sensitive to
Firm Performance
Pay sensitivity to performance has been documented for a range of countries, including the USA, the UK and Germany.
However, other factors have also been shown to have an effect
firm size, and
ownership and control.
Is Managerial Compensation Sensitive to
Firm Performance (Continued)
This suggests that executive directors benefit from empire building via increased salaries.
The empirical evidence suggests that this is a concern
Firms where managerial compensation is sensitive to firm size are more likely to conduct acquisitions
Managers experience a net increase in their compensation despite the drop in post-acquisition stock performance and sales
5.*
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
Managerial compensation increases in line with good post-acquisition performance, but is insensitive to bad performance
In contrast, changes in compensation after large capital expenditures are much smaller and also more sensitive to poor performance
Managers seem to use the higher information asymmetry surrounding acquisitions to boost their compensation.
Is Managerial Compensation Sensitive to
Firm Performance (Continued)
Another factor influencing managerial pay is ownership and control
Widely held firms have been reported to have higher managerial compensation than firms with large shareholders
This suggests that large shareholder monitoring is a substitute for managerial incentivising via compensation packages.
Is Managerial Compensation Sensitive to
Firm Performance (Continued)
Some argue that
managerial compensation is unlikely to address corporate governance issues, and
it is a corporate governance issue in itself as directors of firms with poor governance are able to set their own, excessive pay.
Managerial pay has also been shown to be asymmetric as
it increases with good luck,
but not with bad luck.
Is Managerial Compensation Sensitive to
Firm Performance (Continued)
Lucian Bebchuk and Jesse Fried go one step further.
They argue that managers are entirely self-serving and they maximise their pay subject to a public outrage constraint.
Is Managerial Compensation Sensitive to
Firm Performance (Continued)
How Should One Design Managerial
Compensation Contracts?
There is an extensive theoretical and empirical literature on the design of managerial compensation.
Both stock ownership and stock options have their advantages and drawbacks.
Stock ownership seems to make managers even more risk averse given its downside.
Stock options address this issue as they have a limited downside.
However, they also seem to exacerbate conflicts of interests between managers and shareholders.
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Managerial Ownership
The principal–agent problem stems from the separation of ownership and control.
One way of mitigating this problem is to give managers shares in their firm.
However, managerial ownership may also entrench managers.
Hence, there may be two sides to managerial ownership.
5.*
Managerial Ownership (Continued)
Two types of studies analyse the link between performance and managerial ownership
Those that assume ownership to be exogenous, i.e. determined outside the system
Those that assume ownership to be endogenous, i.e. ownership may depend on firm characteristics such as past performance.
5.*
Studies Assuming Managerial Ownership
Morck, Shleifer and Vishny allow for a non-linear relationship between managerial ownership and firm value for the USA.
They find evidence of such a non-linear relationship
Firm value rises with ownership in the 0–5% region
It then decreases in the 5–25% region to reach its minimum value
It then increases again above 25% ownership, but at a decreasing rate.
5.*
Studies Assuming Managerial Ownership
to be Exogenous (Continued)
It has low explanatory power
Being a US study, there is low cross-sectional variation of ownership
The study ignores non-managerial ownership.
5.*
Studies Assuming Managerial Ownership
to be Exogenous (Continued)
Karen Wruck looks at 128 US firms with large changes of ownership.
She includes non-managerial ownership.
She replicates the Morck et al. model
She finds the same effects for the 0–5% and 5–25% ranges
However, she only finds a positive effect in the 25–100% range when she considers total ownership.
5.*
Studies Assuming Managerial Ownership
to be Exogenous (Continued)
John McConnell and Henri Servaes clearly distinguish between managerial and non-managerial ownership.
They find a curvilinear link between firm value and managerial ownership.
Firm value reaches its maximum in the 40–50% ownership range.
They also find a positive linear link between firm value and institutional ownership.
5.*
Studies Assuming Managerial Ownership
to be Exogenous (Continued)
Studies Assuming Managerial Ownership
to be Endogenous (Continued)
These studies allow for current managerial ownership to depend on past firm characteristics, including firm performance.
These studies do not tend to find a link between managerial ownership and firm value.…
5.*
Lecture Aims
This lecture reviews the main devices or mechanisms that are believed to ensure that managers run the firm in the interests of the shareholders and punish badly performing managers. The lecture assesses the effectiveness and importance of these mechanisms across various corporate governance systems. It covers among others the following mechanisms: the market for corporate control and hostile takeovers, dividend policy, the board of directors, institutional shareholders, shareholder activism, managerial compensation, managerial ownership, monitoring by large shareholders and creditors/banks.
5.*
Learning Outcomes
By the end of this lecture, you should be able to:
Assess the importance of various corporate governance devices across the main systems of corporate governance
Judge the efficiency of the various devices in terms of preventing bad performance by the management and/or disciplining bad managers
Critically evaluate the empirical research on the importance and effectiveness of corporate governance devices
Identify the gaps in the existing literature.
5.*
Corporate governance devices or mechanisms are arrangements that mitigate conflicts of interests corporations may face.
These conflicts of interests are those that may arise between
the providers of finance and managers,
the shareholders and the stakeholders, and
different types of shareholders (mainly the large shareholder and the minority shareholders).
Introduction
5.*
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
Particular corporate governance mechanisms are more likely to prevail in one corporate governance system than in others.
The reason is that the prevalence of the above conflicts of interests is also likely to vary across systems.
Hence, in order to study the effectiveness of the various corporate governance devices, one needs to adopt one of the taxonomies of corporate governance systems.
Introduction (Continued)
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
We adopt the taxonomy by Julian Franks and Colin Mayer which distinguishes between insider and outsider systems.
We adopt this taxonomy for two reasons
It does not advocate the superiority of one system
It provides a broad, yet convenient framework to analyse the various corporate governance devices.
Introduction (Continued)
Product Market Competition
Competition in product and service markets may reduce managerial slack across all corporate governance systems.
For example, a French manufacturer of household appliances operates in the same global market as manufacturers from other countries.
If the French manufacturer suffers from weak corporate governance, it may ultimately be driven out of the market.
5.*
Product Market Competition (Continued)
Benjamin Hermalin has developed a theoretical model about the effects of competition on managerial (agent) performance.
He argues that competition has four distinct effects on managerial performance
the income effect,
the risk-adjustment effect,
5.*
The income consists of the following
expected income decreases with increased competition,
but it also puts pressure on managers to perform better by e.g. reducing their perks as well as other costs.
The risk-adjustment effect concerns the fact that competition changes the riskiness of the various actions managers can take.
Product Market Competition (Continued)
The change-in-information effect consists of the following
Competition makes it easier for the principal to judge the agent’s actions as there is now a (larger) peer group of other companies
Competition also has an effect on managerial actions by reducing the riskiness of both easy and hard actions
However, the decrease in riskiness may not necessarily be uniform across both easy and hard actions
Hence, it is not clear whether managers will switch from easy to hard actions or the converse.
Product Market Competition (Continued)
Increased competition also changes the relative value of managerial actions
By reducing the price cap, competition reduces the agent’s expected income and hence his incentives to work hard
However, it also increases the value attached to cost saving actions by the agent, making the latter work harder.
A priori, all of the above four effects have ambiguous signs.
Hermalin shows that under certain conditions the positive income effect will dominate and competition will increase managerial performance.
Product Market Competition (Continued)
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
However, generally it is still not clear whether increased competition increases or decreases managerial performance.
While empirical evidence on the effect of competition is still sparse, the studies that exist suggest that
competition forces managers to work harder, and
it may even be a substitute for good corporate governance.
Product Market Competition (Continued)
Incentivising and Disciplining Managers
in the Insider and Outsider Systems
The main mechanisms that are thought to keep managers in check in the outsider system are
the market for corporate control (= hostile takeover?),
dividend policy,
*
- concentrated control and complex ownership structures,
- managers being monitored and disciplined by the large shareholder, and
- underdeveloped takeover and stock markets.
Outsider systems are characterised by
- dispersed ownership and control,
Slide 5.*
Incentivising and Disciplining Managers
In the insider system, they are
monitoring by large shareholders, and
monitoring by banks and other large creditors.
5.*
The Market for Corporate Control
The disciplinary role of the market for takeovers was first proposed by Henry Manne.
Badly performing firms see their share price drop.
They then become easy targets for hostile raiders intend on changing the management, thereby creating firm value.
However, the empirical evidence does not support Manne’s argument.
5.*
The Market for Corporate Control (Continued)
A US study by William Schwert and a UK study by Julian Franks and Colin Mayer investigate the pre-acquisition performance of targets of hostile takeovers and targets of friendly takeovers.
Hostility is defined as the target management’s attitude toward the proposed takeover bid.
Neither the US nor the UK study finds any difference in the pre-acquisition performance of both types of targets.
5.*
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
However, the mere threat of a hostile takeover may be enough to ensure that managers do not shirk.
Still, hostile takeovers are an extreme and expensive mechanism to correct managerial failure.
They also tend to be very rare outside the UK and the USA.
The Market for Corporate Control (Continued)
5.*
Dividends and Dividend Policy
Frank Easterbrook and Michael Rozeff were the first to formalise the corporate governance role of dividends.
In Rozeff’s model, dividends reduce agency costs by reducing the free cash flow.
However, they also increase transaction costs as higher dividends increase the need for costly external financing.
Hence, there is an optimal dividend payout which minimises the sum of both costs.
5.*
Dividends and Dividend Policy (Continued)
Easterbrook also argues that by committing to high dividends the free cash flow is kept to a minimum and wastage by the managers is reduced.
In addition, the firm has to raise regularly outside finance.
Each time it does so it subjects itself to the scrutiny of outsiders.
If the managers have been performing badly, then outside finance is unlikely to be made available.
5.*
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
For dividends to be able to fulfil their disciplinary role, they need to be sticky.
Managers will need to carry on paying dividends even if profits are down temporarily.
The role of dividends is likely to be more important in the outsider system given the lack of shareholder monitoring.
Dividends and Dividend Policy (Continued)
5.*
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
Marc Goergen, Luc Renneboog and Luis Correia da Silva study the flexibility of German dividends compared to UK and US dividends.
They find that, when profits are down temporarily, German firms are much more willing to cut or omit their dividends than UK and US firms.
German firms controlled by banks are even more willing to cut or omit their dividends.
They conclude that large shareholder monitoring acts as a substitute for dividends.
Dividends and Dividend Policy (Continued)
5.*
Boards of Directors
UK and US firms as well as firms from most other countries have a single-tier board where both executive and non-executive directors sit.
A few countries, such as Germany and China, have two separate boards, the so called two-tier board.
The two-tier board consists of
the supervisory board where the non-executives (as well as maybe employee representatives) sit, and
the management board where the executives sit.
5.*
Boards of Directors (Continued)
There is an ongoing debate about whether a single- or two-tier board is better.
Some argue that having two boards ensures the independence of the non-executives from the executives.
Others argue that having two boards prevents the non-executives from being effective monitors due to a lack of information.
5.*
Is there a link between board structure and financial performance?
Do boards fire executives in the wake of poor performance?
What factors determine board changes?
Should the roles of the chairman and the CEO be separated?
Boards of Directors (Continued)
Is There a Link between Board Structure
and Financial Performance?
The proportion of non-executives is normally used as a measure of board independence.
Boards that are dominated by non-executives are likely to be more independent from the management.
However, there is little evidence in support of a positive link between firm performance and board independence.
However, board composition may not be exogenous, i.e. it may not be randomly determined.
5.*
Is There a Link between Board Structure
and Financial Performance? (Continued)
For example, board composition may be determined by past performance.
If poor performance causes an increase in the number of non-executives, then this would explain why no link has been found between firm performance and board independence.
In contrast, there is conclusive evidence that large boards are bad for firm performance.
There is also evidence that interlocked directorships cause collusion.
5.*
Do Boards Fire Executive Directors in
the Wake of Poor Performance?
There is consistent evidence of an increase in CEO and board turnover in the wake of poor performance.
There is such evidence for both corporate governance systems
the outsider system of the UK and the USA, as well as
the insider system of Germany and Japan.
However, board dismissals cannot be equated to good corporate governance.
Managerial dismissals also only occur in cases of extremely poor performance.
5.*
What Factors Determine Board Changes?
Benjamin Hermalin and Michael Weisbach find that
inside directors are more likely to be replaced by outside directors in poorly performing companies;
inside directors normally replace retiring CEOs;
when the CEO is replaced by an outsider, some inside directors – possibly the losers in the contest to the succession – leave the firm; and
firms leaving their product market replace their inside directors with outside directors.
5.*
What Factors Determine Board Changes?
(Continued)
Steven Kaplan and Bernadette Minton find that banks appoint representatives to the boards of poorly performing Japanese firms that are part of keiretsus.
5.*
Should the Roles of the Chairman and
CEO Be Separated?
There has been an ongoing debate as to whether the roles of the chairman and the CEO should be separated or whether duality is preferable.
Proponents of duality base themselves on the following three arguments
Duality ensures that there is strong leadership
Splitting the two roles may create tensions between the CEO and chairman
Having a separate CEO and chairman makes it difficult to designate a single spokesperson for the company.
5.*
Should the Roles of the Chairman and
CEO Be Separated? (Continued)
Those opposed to duality argue that
Combining the two roles reduces board independence and increase CEO entrenchment
It combines the role of monitoring the executives and leading the executives in a single person.
In the USA, minds are still split as to whether duality is good or bad.
The empirical evidence on US firms is also as yet inconclusive.
5.*
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
In contrast, in the UK successive codes of best practice in corporate governance have recommended the separation of the two roles.
In contrast to US evidence which is inconclusive, evidence from UK firms seems to suggest that duality has no effect on performance.
Should the Roles of the Chairman and
CEO Be Separated? (Continued)
Institutional Investors (Continued)
Institutional investors are the most important types of shareholders in the UK and the USA as well as a few other countries (e.g. the Netherlands).
However, the jury is still out as to whether institutional investors monitor the management of their investee firms.
5.*
They reduce the levels of managerial pay.
Institutional Investors (Continued)
They reduce firm value
They have short-term horizons
Institutional Investors (Continued)
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
In the UK, successive codes of best practice in corporate governance have urged institutional investors to become more active.
The 2001 Myners Report states that
institutional investors “remain unnecessarily reluctant to take an activist stance in relation to corporate underperformance, even where this would be in their clients’ financial interests”.
A number of UK studies suggest that institutional investors are mostly passive and prefer exit over voice.
Institutional Investors (Continued)
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
Jana Fidrmuc, Marc Goergen and Luc Renneboog study the price reaction to insider trades in UK firms
They expect that monitoring reduces the information conveyed by insider trades.
They find that the price reaction
is highest for firms dominated by institutional investors, and
lowest for firms dominated by families and other firms.
They interpret this as evidence that institutional investors are passive.
Institutional Investors (Continued)
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
However, evidence from case study research by Marco Becht and others suggests that institutional investors act behind the scenes.
Still, from an agency perspective it is not clear why institutional investors should be the panacea (wondermiddel) to all corporate governance issues.
Institutional Investors (Continued)
Shareholder Activism
Shareholders may prefer to act behind the scenes to address poor managerial performance in their investee firms.
However, they may use so called proxy contests as a means of last resort if management remains unresponsive.
Proxy contests consist of soliciting the support of other shareholders, via their votes, to bring about change.
5.*
Shareholder Activism (Continued)
While shareholder-initiated proxy voting is frequent in the USA and on the increase in the UK, it is relatively rare in Continental Europe.
Whereas proxy contests are relatively successful in the USA, they are less successful in the UK and Continental Europe.
Nevertheless, managers of US firms are not legally bound to implement shareholder proposals whereas they have to in the UK and most of Continental Europe.
5.*
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
The stock market reaction to proxy contests is also different between the USA and the UK-Continental Europe
In the USA, the stock price reaction is normally positive
In the UK and Continental Europe, it is negative suggesting that the market interprets proxy contests as a signal of shareholder discontent rather than positive change.
Shareholder Activism (Continued)
Managerial Compensation
One possible way of aligning the interests of the managers with those of the shareholders is managerial compensation.
By making managerial compensation sensitive to firm performance, managers should have the right incentives to maximise shareholder value.
5.*
Managerial Compensation (Continued)
the base (or cash) compensation,
long-term incentive plans (LTIPs) such as stock options and restricted stock grants,
benefits, and
Figure 1 – Level and composition of CEO pay for 2005
Slide 5.*
5.*
Is Managerial Compensation Sensitive to
Firm Performance
Pay sensitivity to performance has been documented for a range of countries, including the USA, the UK and Germany.
However, other factors have also been shown to have an effect
firm size, and
ownership and control.
Is Managerial Compensation Sensitive to
Firm Performance (Continued)
This suggests that executive directors benefit from empire building via increased salaries.
The empirical evidence suggests that this is a concern
Firms where managerial compensation is sensitive to firm size are more likely to conduct acquisitions
Managers experience a net increase in their compensation despite the drop in post-acquisition stock performance and sales
5.*
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
Managerial compensation increases in line with good post-acquisition performance, but is insensitive to bad performance
In contrast, changes in compensation after large capital expenditures are much smaller and also more sensitive to poor performance
Managers seem to use the higher information asymmetry surrounding acquisitions to boost their compensation.
Is Managerial Compensation Sensitive to
Firm Performance (Continued)
Another factor influencing managerial pay is ownership and control
Widely held firms have been reported to have higher managerial compensation than firms with large shareholders
This suggests that large shareholder monitoring is a substitute for managerial incentivising via compensation packages.
Is Managerial Compensation Sensitive to
Firm Performance (Continued)
Some argue that
managerial compensation is unlikely to address corporate governance issues, and
it is a corporate governance issue in itself as directors of firms with poor governance are able to set their own, excessive pay.
Managerial pay has also been shown to be asymmetric as
it increases with good luck,
but not with bad luck.
Is Managerial Compensation Sensitive to
Firm Performance (Continued)
Lucian Bebchuk and Jesse Fried go one step further.
They argue that managers are entirely self-serving and they maximise their pay subject to a public outrage constraint.
Is Managerial Compensation Sensitive to
Firm Performance (Continued)
How Should One Design Managerial
Compensation Contracts?
There is an extensive theoretical and empirical literature on the design of managerial compensation.
Both stock ownership and stock options have their advantages and drawbacks.
Stock ownership seems to make managers even more risk averse given its downside.
Stock options address this issue as they have a limited downside.
However, they also seem to exacerbate conflicts of interests between managers and shareholders.
5.*
Managerial Ownership
The principal–agent problem stems from the separation of ownership and control.
One way of mitigating this problem is to give managers shares in their firm.
However, managerial ownership may also entrench managers.
Hence, there may be two sides to managerial ownership.
5.*
Managerial Ownership (Continued)
Two types of studies analyse the link between performance and managerial ownership
Those that assume ownership to be exogenous, i.e. determined outside the system
Those that assume ownership to be endogenous, i.e. ownership may depend on firm characteristics such as past performance.
5.*
Studies Assuming Managerial Ownership
Morck, Shleifer and Vishny allow for a non-linear relationship between managerial ownership and firm value for the USA.
They find evidence of such a non-linear relationship
Firm value rises with ownership in the 0–5% region
It then decreases in the 5–25% region to reach its minimum value
It then increases again above 25% ownership, but at a decreasing rate.
5.*
Studies Assuming Managerial Ownership
to be Exogenous (Continued)
It has low explanatory power
Being a US study, there is low cross-sectional variation of ownership
The study ignores non-managerial ownership.
5.*
Studies Assuming Managerial Ownership
to be Exogenous (Continued)
Karen Wruck looks at 128 US firms with large changes of ownership.
She includes non-managerial ownership.
She replicates the Morck et al. model
She finds the same effects for the 0–5% and 5–25% ranges
However, she only finds a positive effect in the 25–100% range when she considers total ownership.
5.*
Studies Assuming Managerial Ownership
to be Exogenous (Continued)
John McConnell and Henri Servaes clearly distinguish between managerial and non-managerial ownership.
They find a curvilinear link between firm value and managerial ownership.
Firm value reaches its maximum in the 40–50% ownership range.
They also find a positive linear link between firm value and institutional ownership.
5.*
Studies Assuming Managerial Ownership
to be Exogenous (Continued)
Studies Assuming Managerial Ownership
to be Endogenous (Continued)
These studies allow for current managerial ownership to depend on past firm characteristics, including firm performance.
These studies do not tend to find a link between managerial ownership and firm value.…