Trends Slides

7/28/2019 Trends Slides

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Trends in Corporate

Governance

Benjamin E. Hermalin

UC Berkeley


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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.


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How do these trends relate?

Are these trends independent?

Are they linked?

If so, what has led to what?

And what do these links tell us about

governance?

And, thus, about the consequences, intended

and unintended, of externally imposedreform?


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How to think about governance

Imported from Hermalin & Weisbach 2003

Spuriouscorrelation

Exhibit 1

Heuristic Illustration of the Distinction between Out-of-Equilibrium

and Equilibrium Explanations for Certain Empirical Results

Boardcharacteristic

Firm performanceor other firm attribute

Out-of -Equilibrium Phenomenon Equilibrium Phenomenon

Causal

Cau

salCa

usal

Board

characteristic

Firm performance

or other firm attribute

Other factors ( such

as the CEO s previous

performance)


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Thinking about governance

The role of directors:

Hire a CEO.

Monitor him(make assessments).

Replace him if necessary.

How you willmonitor

affects who you wish to hire.


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Model: Timing

Board hires

new CEO.

Internal (I)

or External

(E)


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Model: Timing

Board hires

new CEO.

Internal (I)

or External

(E)

Board monitors

with intensityp;

that is, acquiressignal, y, about

CEOs ability with

probabilityp.


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Model: Timing

Board hires

new CEO.

Internal (I)

or External

(E)

Board monitors

with intensityp;


CEOs ability with

probabilityp.

If signal acquired,

Board makes

decision to keep

or fire incumbent

CEO.


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Model: Timing

Board hires

new CEO.

Internal (I)

or External

(E)

Board monitors

with intensityp;


CEOs ability with

probabilityp.

If signal acquired,

Board makes

decision to keep

or fire incumbent

CEO.

Earnings,x,

realized.


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Preferences and ability

Earnings,x, are distributed normally with amean equal to the ability, , of the CEO inplace at the end (i.e., the initial hire or hisreplacement).

Board likesx, but dislikes monitoring effort,p.

Assume behavior of board can be aggregatedto that of a single decision maker with utility

function xc(p), where c() has usual costfunction properties and is a parameter thatreflects diligence.


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Informational assumptions

CEOs 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 andprecision . [Recall precision = 1/variance]

The signal, y, which board receives with

probabilityp, is distributed normally with

mean and precision s.

y - andx- are independently distributed.


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Thinking about incumbent ability

value(ability)

distribution of true

ability.


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value(ability)


ability

expected ability =


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value(ability)


ability

expected ability = expected ability

ofreplacement(which is

normalized

to 0)


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So, absentnew information, want to

keep original CEO (his expected value

greater than replacements)


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Thinking about monitoring


ability

expected ability

expected ability

ofreplacement

bad signal good signal

replace incumbent keep incumbent


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Thinking about monitoring


ability

expected ability

expected ability

ofreplacement

replace incumbent keep incumbent

highly likely

not so likely

bad signal good signal


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Benefit of monitoring

value

(ability)


ability

expected abilityexpected ability

ofreplacement

on average, get

rid of low ability

CEOs

on average, keep

high ability CEOs


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Value of monitoring


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Analysis

Board choosesp to maximize

(pV+(1-p))c(p).

Let P*be the solution.

Proposition 1: The intensity with which theboard monitors the CEO, P*, is

i. decreasing with the prior estimate of hisability, ;

ii. decreasing with the precision of the priorestimate, ; but

iii. Increasing with the boards diligence, .


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Who gets monitored?

value(ability)

estimated

ability of

replacement

more value to monitoring red CEO

than green CEO.


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Who gets monitored?

value(ability)

estimated

ability of

replacement

more value to monitoring red CEO

than green CEO.


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Monitoring and who to hire

value(ability)

ability external

candidate

ability internal

candidate


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value(ability)

ability external

candidate

ability internal

candidate

monitoring means

largely avoid these

values

estimatedability of

replacement

monitoring means

largely keep these

values


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Monitoring means willing to trade a higher estimatedability 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 makethis 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 theseresults.


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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.


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CEO tenure

Recall: No monitoring Always keep

incumbent CEO.

Monitoring some CEOs get fired.

Hence, more monitoring shorter CEOtenures on average.

So, more outsider representation more

monitoring ofallCEOs shorter CEOtenures on average.

Also indirecteffect


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External CEOs more vulnerable

value(ability)

ability external

candidate

ability internal

candidate

likely to draw bad

signal and get fired

estimatedability of

replacement

likely to draw bad

signal and get fired


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External CEOs more vulnerable

value(ability)

ability external

candidate

ability internal

candidate

estimatedability of

replacement

bigger left tail also

means greater

reason to monitor


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Reasons external CEOs more

vulnerable

More likely to have been hired by outsider-

dominated board.

Regardless of board, greater uncertainty

means monitoring more valuable, somonitored more.

Greater uncertainty bigger left tail more

likely to get bad signal.


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Effort and compensation

Suppose that CEOs wish to keep their jobs.

Might make them work harder if effort can

influence boards perception if it monitors.

Equivalently, consume less perquisites if thatinfluence boards perception if it monitors.

This harder work will require compensation.

Even if dont work harder, greater risk oflosing job will require compensation.


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Model: New timing

Board hires

new CEO.

Internal (I)

or External

(E)

Board monitors

with intensityp;

that is, acquires

signal, y+e,

about CEOs

ability with

probabilityp.

If signal acquired,

Board makes

decision to keep

or fire incumbent

CEO.

Earnings,

x+(e),

realized.

Surviving

CEO gets

benefit, b > 0.

CEO

expends

effort, e, at

cost k(e).


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Effort


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Effort

signal

distribution of signal


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Effort

signal

effort shifts the signal to the right,

making CEO seem betterif

monitored


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Effort

signal

effort shifts the signal to the right,

making CEO seem better if

monitored

But in equilibrium boards not

fooled it subtracts back

expectedeffort when inferring

ability


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Effort

signalBut in equilibrium boards not

fooled it subtracts back

expectedeffort when inferring

ability

So even though not

fooling anyone, CEO

has to expend effort or

look even worse!


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Equilibrium of effort model


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Effort

Proposition 5:Assume for the relevantparameter values that the game with CEOeffort has a pure-strategy equilibrium. Thenthe following comparative statics hold:

i. the lower the CEOs estimated ability, themore effort he expends in equilibrium(Avis); and

ii. the more diligent is the board (i.e., thegreater is ), the more effort the CEOexpends in equilibrium.


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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 effortper se. The greater effort is induced indirectly

because the CEO is trying to look more able.

His efforts are for naught in equilibrium, butmust still work harder.


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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 diligentboards will receive greater compensation

than CEOs who work for less diligent boards.


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Compensation without effort

Even in the model withouteffort, working for a more

diligent board is less desirable than working for a

less diligent board.

Higher compensation as compensating differential:

Proposition 7: If the market for CEOs is

homogenous, then

i. firms with more diligent boards pay more than firms

with less diligent boards; and

ii. as diligence increases over time across firms,

average CEO compensation will also increase.


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Time series and cross section

The last predictions might seem at odds withpredictions of some who argue that it is less diligentboards who pay more.

This cross-section prediction can be reconciled with

the time-series prediction if CEOs areheterogeneous:

monitoring and ability are substitutes, so less diligentboards 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 lowerpaid-lower ability CEOs work for more diligent boards.


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Time series and cross section

With heterogeneous CEOs, the following is

feasible within the model: In a cross-section

of firms, at any moment in time, CEO

compensation can vary inversely with thediligence of the board. However, over time,

as boards on average become more diligent,

the trend should be toward an increase in

CEO compensation; that is, across time, CEOcompensation should co-vary positively with

the diligence of the board.


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Putting all the trends together

more

independent

boards (more

outsiders)

more

monitoring

more effort

more external

CEOs

shorter

average

tenures

greater

compensation


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Whats been left out?

The bargaining between board & CEO (see

Hermalin & Weisbach,AER1998)

CEO life-cycle effects (less board

independence as CEO tenure increases)

time

b

oard

independence

firm path

time trend

CEO

tenure


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Conclusions

Many of the trends weve been observing in

corporate governance can be linked via the

boards monitoring role.

Some of the good trends (e.g., moreindependent boards) may yield bad trends

(e.g., greater CEO compensation).

From the perspective of theory, work remains.

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