trends in corporate governance benjamin e. hermalin uc berkeley

Trends in Corporate Governance

Benjamin E. Hermalin

UC Berkeley

What trends?

In US, last twenty-five years have seen significant shift toward more outsider representation on the board.

In US, trend toward more external hiring of CEO. Similar trends emerging in UK. In US, trend toward greater CEO compensation (both

contingent and non-contingent). In US, trend toward shorter CEO tenures In US, renewed efforts at reform SOx, NYSE, etc.

Questions?

How do these trends relate? What do they tell us about organization?

Thinking about governance

The role of directors: Hire a CEO. Monitor him

(make assessments). Replace him if necessary.

How you will monitoraffects who you wish to hire.

Model: Timing

Board hires new CEO. Internal (I) or External (E)

Model: Timing


Board monitors with intensity p; that is, acquires signal, y, about CEO’s ability with probability p.

Model: Timing



If signal acquired, Board makes decision to keep or fire incumbent CEO.

Model: Timing




Earnings, x, realized.

Preferences and ability

Earnings, x, are distributed normally with a mean equal to the ability, , of the CEO in place at the end (i.e., the initial hire or his replacement).

Board likes x, but dislikes monitoring effort, p. Assume behavior of board can be aggregated

to that of a single decision maker with utility function x – c(p), where c() has usual cost function properties and is a parameter that reflects diligence.

Informational assumptions

CEO’s ability, , is fixed throughout his career. It is unknown, ex ante, by anyone, but it is common knowledge that is the draw from a normal distribution with mean and precision . [Recall precision = 1/variance]

The signal, y, which board receives with probability p, is distributed normally with mean and precision s.

Thinking about incumbent ability

value(ability)

distribution of trueability.


value(ability)

distribution of trueability

expected ability =


value(ability)


expected ability = expected abilityof replacement(which isnormalizedto 0)


So, absent new information, want to keep original CEO (his expected value greater than replacement’s)

Thinking about monitoring


expected ability

expected abilityof replacement

bad signal good signal

replace incumbent keep incumbent

Thinking about monitoring


expected ability

expected abilityof replacement

replace incumbent keep incumbent

highly likely

not so likely

bad signal good signal

Benefit of monitoring

value(ability)


expected abilityexpected abilityof replacement

on average, get rid of low ability CEOs

on average, keep high ability CEOs

Analysis

Proposition 1: The intensity with which the board monitors the CEO is

i. decreasing with the prior estimate of his ability, ;

ii. decreasing with the precision of the prior estimate, ; but

iii. Increasing with the board’s diligence, .

Who gets monitored?

value(ability)

estimatedability ofreplacement

more value to monitoring red CEO than green CEO.

Monitoring and who to hire

value(ability)

ability externalcandidate

ability internalcandidate


value(ability)



monitoring means largely avoid these values


monitoring means largely keep these values


Monitoring means willing to trade a higher estimated ability for greater uncertainty about ability.

External candidates have “an edge.” But note: This result relies on the assumption that the

CEO will be monitored: Lower the probability of getting signal of ability (i.e.,

less intensely CEO monitored), less willing to make this tradeoff.

Boards who are more inclined to monitor will have a greater tendency to hire external candidates.

See Proposition 2 for a formal statement of these results.

Two trends related

Outside directors are generally thought to be more inclined to monitor: Theoretical reasons (e.g., inside directors too

closely tied to incumbent manager); Anecdotal/field work evidence (e.g., Mace); & Statistical evidence (e.g., Weisbach).

So a trend toward greater outsider representation on boards should lead to more external candidates being hired.

CEO tenure

Recall: No monitoring Always keep incumbent CEO.

Monitoring some CEOs get fired. Hence, more monitoring shorter CEO

tenures on average. So, more outsider representation more

monitoring of all CEOs shorter CEO tenures on average.

Also indirect effect …

External CEOs more vulnerable

value(ability)



likely to draw bad signal and get fired


likely to draw bad signal and get fired

bigger left tail also means greater reason to monitor

Effort Model: New timing


Board monitors with intensity p; that is, acquires signal, y+e, about CEO’s ability with probability p.


Earnings, x+(e), realized.

Surviving CEO gets benefit, b > 0.

CEO expends effort, e, at cost k(e).

Effort

signal

distribution of signal

Effort

signal

effort shifts the signal to the right, making CEO seem better if monitored

Effort

signal

effort shifts the signal to the right, making CEO seem better if monitored

But in equilibrium board’s not fooled — it subtracts back expected effort when inferring ability

Effort

signalBut in equilibrium board’s not fooled — it subtracts back expected effort when inferring ability

So even though not “fooling” anyone, CEO has to expend effort or look even worse!

Effort

Proposition 5: Assume for the relevant parameter values that the game with CEO effort has a pure-strategy equilibrium. Then the following comparative statics hold:

i. the lower the CEO’s estimated ability, the more effort he expends in equilibrium (“Avis”); and

ii. the more diligent is the board (i.e., the greater is ), the more effort the CEO expends in equilibrium.

Result ii.

Result ii. predicts that greater board diligence leads to more effort from CEO.

Might seem a “no brainer”; but recall no monitoring of effort per se. The greater effort is induced indirectly

because the CEO is trying to look more able. His efforts are for naught in equilibrium, but

must still work harder.

Effort and compensation

Proposition 6: If CEOs with similar attributes enjoy equal expected utility in the equilibrium of the CEO labor market, then, controlling for attributes, CEOs who work for more diligent boards will receive greater compensation than CEOs who work for less diligent boards.

Even in the model without effort, working for a more diligent board is less desirable than working for a less diligent board.

Higher compensation as compensating differential.

Time series and cross section

Last predictions might seem at odds with predictions of some that it is less diligent boards who pay more.

This cross-section prediction can be reconciled with the time-series prediction if CEOs are heterogeneous: monitoring and ability are substitutes, so less diligent boards

have greater demand for ability ceteris paribus; more able CEOs can demand salary premia over less able

CEOs ceteris paribus; hence, in cross section, higher paid-higher ability CEOs can

work for less diligent boards while lower paid-lower ability CEOs work for more diligent boards.

However, over time, as boards on average become more diligent, the trend should be toward an increase in CEO compensation

Putting all the trends together

more independent boards (more outsiders)

more monitoring

more effort

more external CEOs

shorter average tenures

greater compensation

Conclusions

Many of the trends we’ve been observing in corporate governance can be linked via the board’s monitoring role.

Some of the “good” trends (e.g., more independent boards) may yield “bad” trends (e.g., greater CEO compensation).

From the perspective of theory, work remains.

trends in corporate governance benjamin e. hermalin uc berkeley

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