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26 1. Corporate Governance 0 5 10 15 20 Normal performance Poor performance 14.3 18.9 9.9 12.4 17.4 Japan Germany U.S. 18.9 Figure 1.2 Top executive turnover and stock returns. Source: built from data in Kaplan (1994a,b). Perhaps more surprisingly in view of the substantial institutional differences, the relationship between poor performance and top executive turnover is similar in the United States, Germany, and Japan: see Figure 1.2, drawn from the work of Kaplan. More recent research (see, for example, Goyal and Park 2002) has confirmed the dual pattern of an increase in forced executive turnover in the wake of poor performance and of an increased sensitivity of this relationship when there are few insiders on the board. The threat of bankruptcy also keeps managers on their toes. Even in the United States, a country with limited creditor protection and advantageous treatment of managers during restructurings,43 52% of financially distressed firms experience a senior management turnover as opposed to 19% for firms with comparably poor stock performance but not in financial distress (Gilson 1989). Are explicit and implicit incentives complements or substitutes? The threat of dismissal or other interferences resulting from poor performance provides incentives for managers over and beyond those provided by explicit incentives. Explicit and implicit incentives are therefore substitutes: with stronger implicit incentives, fewer stocks and stock options are needed to curb managerial moral hazard. While this substitution effect is real,44 the strengths of 43. Under U.S. law’s Chapter 11, which puts a hold on creditor claims, the firm is run as a going concern and no receiver is designated. 44. Gibbons and Murphy (1992) analyze the impact of implicit incentives on optimal explicit incentive contracts in a different context. They posit career concerns à la Holmström (1982b): successful employees receive with a lag external offers, forcing their firm to raise their wage to keep them. Their model has a fixed horizon (and so does not apply as it stands to the executive turnover issue); it shows implicit and explicit incentives are codetermined by sources of heterogeneity in the sample and so other factors (analyzed in Chapters 4 and 6 of this book), impact the observed relationship between implicit and explicit incentives (the survey by Chiappori and Salanié (2003) provides an extensive discussion of the need to take account of unobserved heterogeneity in the econometrics of contracts). First, consider the heterogeneity in the intensity of financial constraints. A recurrent theme of this book will be that the tighter the financing constraint, the more concessions the borrower must make in order to raise funds. And concessions tend to apply across the board. Concessions of interest here are reductions in performance-based pay and in the ability to retain one’s job after poor performance, two contracting attributes valued by the executive. Thus, a tightly financially constrained manager will accept both a lower level of performance-based rewards and a smaller probability of keeping her job after a poor performance (see Section 4.3.5), where the probability of turnover is determined by the composition of the board, the presence of takeover defenses, the specification of termination rights (in the case of venture capital or alliance financing) and other contractual arrangements. The heterogeneity in the intensity of financial constraints then predicts a positive comovement of turnover under poor performance and low-powered incentives. Implicit and explicit incentives then appear to be complements in the sample. Second, consider adverse selection, that is, the existence of an asymmetry of information between the firm and its investors. Investors are uncertain about the likely performance of the executive. An executive who is confident about the firm’s future prospects knows that she is relatively unlikely to achieve a poor performance, and so accepting a high turnover in the case of poor performance is less costly than it would be if she were less confident in her talent or had unfavorable information about the firm’s prospects. Thus, the confident executive is willing to trade that implicit and explicit incentives are indeed substitutes: as the employee gets closer to retirement, career concerns decrease and the employer must raise the power of the explicit incentive scheme. Gibbons and Murphy further provide empirical support for this theoretical prediction
200 2.4
1.2. Managerial Incentives: An Overview 27 off a high performance-based reward against an increased turnover probability in the case of poor performance (see Chapter 6). By contrast, less confident managers put more weight on their tenure and less on monetary compensation. The prediction is then one of a negative covariation between turnover in the case of poor performance45 and low-powered incentives. Put differently, implicit and explicit incentives come out as being substitutes in the sample.46 Interestingly, Subramanian et al. (2002) find that, in their sample, CEOs with greater explicit incentives also face less secure jobs. 1.2.4 Monitoring Monitoring of corporations is performed by a variety of external (nonexecutive) parties such as boards of directors, auditors, large shareholders, large creditors, investment banks, and rating agencies. To understand the actual design of monitoring structures, it is useful to distinguish between two forms of monitoring, active and speculative, on the basis of two types of monitoring information, prospective and retrospective. Active monitoring consists in interfering with management in order to increase the value of the investors’ claims. An active monitor collects information that some policy proposed or followed by management (e.g., the refusal to sell the firm to a high bidder or to divest some noncore assets) is valuedecreasing and intervenes to prevent or correct this policy. In extreme cases, the intervention may be the removal of current management and its replacement by a new management more able to handle the firm’s future environment. Active monitoring is forward looking and analyzes the firm’s past actions only to the extent that they can still be altered to raise firm value or that they convey information (say, about the ability of current management) on which one can act to improve the firm’s prospects. 45. Note that this is indeed a conditional probability: confident managers are less likely to reach a poor performance. 46. The theoretical model in Subramanian et al. (2002) emphasizes a third consideration by making learning from performance about talent sensitive to managerial effort. Then a high-powered incentive scheme, by increasing effort, also increases the informativeness of performance. This increased informativeness, if turnover is otherwise unlikely due to switching costs, in turn may raise turnover. Put differently, the manager is more likely to be found untalented if she exerts a high effort and fails. The mechanism by which the change is implemented depends on the identity of the active monitor. A large shareholder may sit on the board and intervene in that capacity. An institutional investor in the United States or a bank holding a sizeable number of the firm’s shares as custodian in Germany may intervene in the general assembly by introducing resolutions on particular corporate policy issues; or perhaps they may be able to convince management to alter its policy under the threat of intervention at the general meeting. A raider launches a takeover and thereby attempts to gain control over the firm. Lastly, creditors in a situation of financial distress or a receiver in bankruptcy force concessions on management. While active monitoring is intimately linked to the exercise of control rights, speculative monitoring is not. Furthermore, speculative monitoring is partly backward looking in that it does not attempt to increase firm value, but rather to measure this value, which reflects not only exogenous prospects but also past managerial investments. The object of speculative monitoring is thus to “take a picture” of the firm’s position at a given moment in time, that is, to take stock of the previous and current management’s accomplishments to date. This information is used by the speculative monitor in order to adjust his position in the firm (invest further, stay put, or disengage), or else to recommend or discourage investment in the firm to investors. The typical speculative monitor is the stock market analyst, say, working for a passive institutional investor, who studies firms in order to maximize portfolio return without any intent to intervene in the firms’ management. But, as the examples above suggest, it would be incorrect to believe that speculative monitoring occurs only in stock markets. A short-term creditor’s strategy is to disengage from the firm, namely, to refuse to roll over the debt, whenever he receives bad news about the firm’s capacity to reimburse its debt. Or, to take other examples, an investment bank that recommends purchasing shares in a company or a rating agency that grades a firm’s public debt both look at the firm’s expected value and do not attempt to interfere in the firm’s management in order to raise this value. They simply take a picture of the firms’
d
28 1. Corporate Governance resources and prospects in order to formulate their advice. Another seemingly unusual category of speculative monitoring concerns legal suits by shareholders (or by attorneys on behalf of shareholders) against directors. Like other instances of speculative monitoring, legal suits are based on backward-looking information, namely, the information that the directors have not acted in the interest of the corporation in the past; per se they are not meant to enhance future value, but rather to sanction past underperformance. Two kinds of legal suits are prominent in the United States: class-action suits on behalf of shareholders, and derivative suits on behalf of the corporation (that is, mainly shareholders, but also creditors and other stakeholders to the extent that their claim is performance-sensitive), which receives any ensuing benefits. While the mechanism of speculative monitoring and its relationship with active monitoring will be explored in detail in Part III of this book, it is worth mentioning here that speculative monitoring does discipline management in several ways. Speculative monitoring in the stock market makes the firm’s stock value informative about past performance; this value is used directly to reward management through stock options and, indirectly, to force reluctant boards to admit poor performance and put pressure on or remove management. Speculative monitoring by short-term creditors, investment banks, or rating agencies drains liquidity from (or restricts funding to) poorly performing firms. Either way, speculative monitoring helps keep managers on their toes. A second and important point is that monitoring is performed by a large number of other “eyeballs”: besides stock analysts, rating agencies assess the strength of new issues. Auditors certify the accounts, which in part requires discretionary assessments such as when they evaluate illiquid assets or contingent liabilities. A long-standing issue has resurfaced with the recent scandals. These eyeballs may face substantial conflicts of interest that may alter their assessment (indeed, many reform proposals suggest reducing these conflicts of interest). For example, a bank’s analysts may overhype a firm’s stocks to investors in order to please the firm from which the investment banking branch tries to win business in mergers and acquisitions and in security underwriting.47 Accountants may face similar conflicts of interest if they also, directly or indirectly, act as directors, brokers, underwriters, suppliers of management or tax consulting services, and so forth.48 Unsurprisingly, a number of countries (e.g., United States, United Kingdom, Italy) have moved from selfregulation of the accounting profession to some form of government regulation. In the United States, the Sarbanes–Oxley Act of 2002 created a regulatory body49 to set rules for, inspect, and impose penalties on public accounting firms.50 1.2.5 Product-Market Competition It is widely agreed that the quality of a firm’s management is not solely determined by its design of corporate governance, but also depends on the firm’s competitive environment. Product-market competition matters for several reasons. First, as already mentioned, close competitors offer a yardstick against which the firm’s quality of management can be measured. It is easier for management to attribute poor performance to bad luck when the firm faces very idiosyncratic circumstances, say, because it is a monopoly in its market, than when competitors presumably facing similar cost and demand conditions are doing well. There is no arguing that 47. For example, Merrill Lynch was imposed a $100 million penalty by the New York Attorney General (2002) when internal emails by analysts described as “junk” stocks they were pushing at the time. Merrill Lynch promised, among other things, to delink analyst compensation and investment banking (Business Week, October 7, 2002). In the same year, Citigroup, or rather its affiliate, Salomon Smith Barney, was under investigation for conflicts between stock research and investment banking activities. 48. In 2001, nonaudit fees make up for over 50% of the fees paid to accounting firms by 28 of the 30 companies constituting the Dow Jones Industrial Average. The California Public Employees’ Retirement System (CalPERS) announced that it would vote against the reappointment of auditors who also provide consulting services to the firm. 49. The Public Company Accounting Oversight Board, overseen by the SEC. 50. DeMarzo et al. (2005) argue that self-regulation leads to lenient supervision. Pagano and Immordino (2004), building on Dye (1993), explicitly model management advisory services as bribes to auditors and study the optimal regulatory environment under potential collusion between firms and their auditors. They show that good corporate governance reduces the incentive to collude and calls for more demanding auditing standards
at least citly,in the fund.Th e for a The Board of Directors and corporate strategy:disposal of asse
1.3. The Board of Directors 29 this benchmarking is used, at least implicitly, in the assessment of managerial performance. Actually, product-market competition improves performance measurement even if the competitors’ actual performance is not observed.51 The very existence of product-market competition tends to filter out or attenuate the exogenous shocks faced by the firm. Suppose the demand in the market is high or the cost of supplies low. The management of a firm in a monopoly position then benefits substantially from the favorable conditions. It can either transform these favorable circumstances into substantial monetary rents if its compensation is very sensitive to profits, or it can enjoy an easy life while still reaching a decent performance, or both. This is not so for a competitive firm. Suppose, for instance, that production costs are low. While they are low for the firm, they are also low for the other firms in the industry, which are then fierce competitors; and so the management is less able to derive rents from the favorable environment. Another related well-known mechanism through which product-market competition affects managerial incentives is the bankruptcy process. Management is concerned about the prospect of bankruptcy, which often implies the loss of the job and in any case a reduction in managerial prerogatives. To the extent that competition removes the cosy cash cushion enjoyed by a monopolist, competition keeps managers alert.52 While competition may have very beneficial effects on managerial incentives, it may also create perverse effects. For example, firms may gamble in order to “beat the market.” A case in point is the intensely competitive market for fund management. Fund managers tend to be obsessed with their ranking in the industry, since this ranking determines the inflow of new investments into the funds and, to a lesser extent due to investor inertia, the flow of 51. This argument is drawn from Rey and Tirole (1986), who, in the context of the choice between exclusive territories and competition between retailers, argue that competition acts as an insurance device and thus boosts incentives. Hermalin (1992) and Scharfstein (1988) study the impact of product-market competition on the agency cost in a Holmström (1979) principal–agent framework. 52. Aghion et al. (1999) develop a Schumpeterian model in which management may be unduly reluctant to adopt new technologies, and show that a procompetition policy may improve incentives in those firms with poor governance structures. money out of the fund. This may induce fund managers to adopt strategies that focus on the ranking of the fund relative to competing funds rather than on the absolute return to investors. It should also be realized that competition will never substitute for a proper governance structure. Investors bring money to a firm in exchange for an expected return whether the firm faces a competitive or protected environment. This future return can be squandered by management regardless of the competitiveness of the product market. And indeed, a number of recent corporate governance scandals (e.g., Barings, Credit Lyonnais, Gan, Banesto, Metallgesellschaft, Enron, WorldCom) have occurred in industries with relatively strong competition. Similarly, the reaction of the big three American automobile manufacturers to the potential and then actual competition from foreign producers was painfully slow. 1.3 The Board of Directors The board of directors53 in principle monitors management on behalf of shareholders. It is meant to define or, more often, to approve major business decisions and corporate strategy: disposal of assets, investments or acquisitions, and tender offers made by acquirers. It is also in charge of executive compensation, oversight of risk management, and audits. 53. We will here be discussing the standard board structure. There are, of course, many variants. One variant that has received much attention is the German two-tier board. For instance, AGs (Aktiengesellschaften) with more than 2,000 employees have (a) a management board (Vorstand) with a leader (Sprecher) playing somewhat the role of a CEO and meeting weekly, say, and (b) a supervisory board (Aufsichtsrat) meeting three or four times a year, appointing members of the Vorstand, and approving or disapproving accounts, dividends, and major asset acquisitions or disposals proposed by the Vorstand. The Vorstand is composed of full-time salaried executives with fixed-term contracts, who cannot be removed except in extreme circumstances, a feature that makes it difficult for an outsider to gain control over the firm. Firm managers cannot be members of the Aufsichtsrat. Half of the members of the Aufsichtsrat are nonexecutive representatives of the shareholders, and half represents employees (both employee delegates and external members designated by trade unions). The shareholders’ representatives are nonexecutives but they are not independent in the Anglo-Saxon sense since they often represent firms or banks with an important business relationship with the firm. The chairman is drawn from the shareholders’ representatives, and breaks ties in case of a deadlock. For more detail about the German two-tier system, see, for example, Charkham (1994, Chapter 2), Edwards and Fischer (1994), Kojima (1997, Section 4.1.2), and Roe (2003)
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30 1. Corporate Governance Lastly, it can offer advice and connections to management. To accomplish these tasks, boards operate more and more often through committees such as the compensation, nominating, and audit committees. Boards have traditionally been described as ineffective rubber-stampers controlled by, rather than controlling, management. Accordingly, there have recently been many calls for more accountable boards.54 1.3.1 Boards of Directors: Watchdogs or Lapdogs? The typical complaints about the indolent behavior of boards of directors can be found in Mace’s (1971) classic book. Directors rarely cause trouble in board meetings for several reasons. Lack of independence. A director is labeled “independent” if she is not employed by the firm, does not supply services to the firm, or more generally does not have a conflict of interest in the accomplishment of her oversight mission. In practice, though, directors often have such conflicts of interest. This is most obvious for insiders sitting on the board (executive directors), who clearly are simultaneously judge and party.55 But nonexecutive directors are often not independent either. They may be handpicked by management among friends outside the firm. They may be engaged in a business relationship with the firm, which they worry could be severed if they expressed opposition to management. 54. In France, the corporate governance movement is scoring points, partly due to the increase in foreign shareholdings (70% of stock market value, but only 13% of the seats on the boards in 1997) and to privatizations. Firms publicize their compliance with the 1995 Viénot report setting up a code of behavior for boards. Yet, the corporate governance movement is still in its infancy. There are very few independent directors. A Vuchot–Ward–Howell study (cited by La Tribune, March 10, 1997) estimated that only 93 directors among the 541 directors of the largest publicly traded French corporations (CAC40) are independent (although French firms widely advertise “outside directors” as “independent directors”). Many are part of a club (and often went to the same schools and issued from the same corps of civil servants) sitting on each other’s boards. The composition of board committees is not always disclosed. And general assemblies are still largely perfunctory, although minority shareholder movements are developing and recent votes demonstrate (minority) opposition to managerial proposals in a number of large companies. 55. The argument that is sometimes heard that insiders should be board members (implying: with full voting rights) in order to bring relevant information when needed is not convincing, since insiders without voting rights could participate in part or all of the board meetings. They may belong to the same social network as the CEO.56 Finally, they may receive “bribes” from the firm; for example, auditors may be asked to provide lucrative consultancy and tax services that induce them to stand with management. In the United States, as in France, the chairman of the board (who, due to his powers, exercises a disproportionate influence on board meetings) is most often the firm’s CEO, although the fraction of large corporations with a split-leadership structure has risen from an historical average of about one-fifth to one-third in 2004.57 Nonexecutive chairmen are much more frequent in the United Kingdom (95% of all FTSE 350 companies in 2004) and in Germany and in the Netherlands (100% in both countries), which have a two-tier board. An executive chairmanship obviously strengthens the insiders’ hold on the board of directors. Another factor of executive control over the board is the possibility of mutual interdependence of CEOs. This factor may be particularly relevant for continental Europe and Japan, where cross-shareholdings within broadly defined “industrial groups” or keiretsus in Japan creates this interdependence. But, even in the United States, where cross-shareholdings are much rarer, CEOs may sit on each others’ boards (even perhaps on each others’ compensation committees!). Insufficient attention. Outside directors are also often carefully chosen so as to be overcommitted. 56. Kramarz and Thesmar (2004) study social networks in French boardrooms. They identify three types of civil-service related social networks in business (more than half of the assets traded on the French stock market are managed by CEOs issued from the civil service). They find that CEOs appoint directors who belong to the same social network. Former civil servants are less likely to lose their job following a poor performance, and they are also more likely than other CEOs to become director of another firm when their own firm is doing badly. Bertrand et al. (2004) investigates the consequences of French CEOs’ political connections. There is a tight overlap between the CEOs and cabinet ministers, who often come from the same corps of civil servants or more generally belong to the same social networks associated with the Ecole Polytechnique or the Ecole Nationale d’Administration. Bertrand et al. find that firms managed by connected CEOs create more (destroy fewer) jobs in politically contested areas, and that the quid pro quo comes in the form of a privileged access to government subsidy programs. 57. According to a September 2004 study by Governance Metrics International, a corporate governance rating agency based in New York (cited in Felton and Wong 2004). Among the firms that have recently separated the roles of chairman and CEO are Dell, Boeing, Walt Disney, MCI, and Oracle