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Boards, Regulators and Monkeys

Boards, Regulators and Monkeys. Renée Adams University of Queensland, Aalto University and ECGI. Roadmap. Why we need to know more about boards The effect of SOX on board activity using a new measure of board activity

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Boards, Regulators and Monkeys

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  1. Boards, Regulators and Monkeys Renée Adams University of Queensland, Aalto University and ECGI

  2. Roadmap • Why we need to know more about boards • The effect of SOX on board activity using a new measure of board activity • What can we learn from monkeys? A closer look at some regulatory responses to the financial crisis • Closing thoughts

  3. Why we need to know more about boards…

  4. What do we know about boards? • Theory suggests that boards play several important roles in corporate governance • Monitoring • Advising • Acting as conduits between firms • Considering the interests of non-shareholder stakeholders (e.g. co-determination) • Huge empirical literature • Relationship between board characteristics and various outcome variables (firm performance, CEO turnover, Q, etc.) • Large array of empirical designs and results

  5. Some evidence for monitoring • Weisbach (1988) CEO turnover is more sensitive to performance when more outsiders on board • Rosenstein and Wyatt (1990) Positive market reaction to appointment of outside directors • Yermack (1996) firms with larger boards have lower Tobin’s Q • Vafeas (1999) Number of board meetings increases in response to poor performance

  6. Some evidence for advising • Boone, Fields, Karpoff and Raheja (2008), Coles Daniel, Naveen (2008), Lehn, Patro and Zhao (2008), Linck, Netter and Yang (2008): board structure varies with proxies for firms’ advising requirements • Duchin, Matsusaka and Ozbas (2009), Ferreira, Ferreira and Raposa (2009), Schmidt (2009): information costs affect board functioning and effectiveness

  7. Corporate scandals in early 2000s • Sarbanes Oxley Act of 2002 • NYSE and Nasdaq listing standards • Majority of independent directors (NYSE) • Independent audit committee, nominating, compensation committee (NYSE) • Financial expert (SOX) → Strengthen board oversight of management

  8. Yet…boards blamed for the financial crisis • Senators Cantwell and Schumer’s proposed Shareholder Bill of Rights: “…among the central causes of the financial and economic crisis that the United States faces today has been a widespread failure of corporate governance” (Cantwell and Schumer, 2009, Section 2) • OECD steering group on corporate governance (Kirkpatrick, 2009): “The financial crisis can be to an important extent attributed to failures and weaknesses in corporate governance arrangements.” • It places much of the blame on board failures in financial firms, in particular • The U.K. Treasury commissioned Sir David Walker to recommend measures to improve board-level governance at banks to the government • The Walker recommendations serve as the basis for a new U.K. Governance Code that took effect in 2010

  9. Did SOX and listing standards work? • Board independence trends • Riskmetrics director data 1996-2007

  10. Did SOX and listing standards work? • Adams (2009) “Governance and the financial crisis”, 2007 data on board independence for banks in Riskmetrics data

  11. Ferreira, Kirchmaier, Metzger (2010): Predicting bailout: US banks, 2006 control variables

  12. Did SOX and listing standards work? • Yes, board structure changed • But, the answer must be no if boards really caused the financial crisis • Can an overemphasis on independence have contributed to the financial crisis? → We need to know more about boards!!!

  13. ? Board structure → board activity • Board size: measure of both advising (+) and monitoring (+ or -) • More expertise and more manpower in complex firms, but free-riding problem • Fraction of “independent” directors: measure of both advising (+ or -) and monitoring (+) • More or less expertise and independence of thought

  14. Measuring what boards do

  15. Adams and Ragunathan (2011) “What do boards do?...” • A new (old) measure of board activity “meeting units” – it measures the amount of activity that the board devotes to its functions • Classify board committees into 3 categories: monitoring, strategy and stakeholder interest • Activity of a committee = product of meetings times size • Task-specific activity = sum of committee activity in each category • If we divide by board size this simply measures the average number of meetings each director attends • We calculate these measures for 1998 Fortune 500 and 2007 Fortune 500

  16. Example: Pfizer Inc. (PFE) • In 2007, Board had 14 members and met 11 times • Committees Committee size # of meetings Audit 4 14 Compensation 4 15 Corporate Governance 4 8 Science & Technology 6 2 Executive 3 0 • Classify committees into one of 3 categories: monitoring, strategy or stakeholder interest • Monitoring: audit, compensation and corporate governance • Strategy: executive, science & technology

  17. “Meeting units (MU)” for Pfizer • At the board level (“TotMU”) and for each task PfizerTotMU = sizeboard * meetboard + [sizeaudit * meetaudit + sizecomp * meetcomp + sizecorp gov * meetcorp gov ] + [sizetech * meettech + sizeexec * meetexec ] • PfizerTotMU = 314 • Monitoring MUs = 148 • Strategy MUs = 12 • Stakeholder MUs = 0 • Fraction of activity at committee level: 51% (160/314)

  18. Some basic statistics • Board size: • 11.27 (1998) • 11.03 (2007) • Board meetings: • 7.84 (1998) • 8.64 (2007) • # of committees: • 4.36 (1998) • 4.69 (2007) → No economically significant differences in board structure inputs into MU calculations on average

  19. Some summary statistics for MU • 1998 averages (344 observations) • TotMU = 158.44 • Committee MU = 66.928 • Monitoring MU = 48.040 • Strategy MU = 13.731 • 2007 averages (368 observations) • TotMU = 201.957 • Committee MU = 106.489 • Monitoring MU = 88.440 • Strategy MU = 12.917

  20. Some observations • Most activity devoted to monitoring: • BUT does not imply boards do not advise - monitoring may be more time intensive • Committee activity represents ~40% of total board activity in 1998 and more than 50% in 2007 • Yet almost no literature on board committees! • Although board structure does not appear economically different: • Boards are working harder in 2007: • Total MU: 27.46% increase • Per person MU: 30.47% increase • Boards are working differently in 2007: • Monitoring MU: 83.89% increase • Strategy MU: 5.92% decrease • Stakeholder MU: 1.4% increase

  21. Board structure and activity • Board size is positively related to every type of activity • Consistent with arguments that board size is a proxy for both monitoring and advising • Casts doubt on common perception that larger boards are necessarily worse • Independence is positively related to total activity, delegation to committees and monitoring activity • Consistent with idea that independence is a proxy for monitoring • Consistent with idea that increases in independence may decrease expertise • Casts doubt on idea that independence may be a good proxy for advice

  22. SOX and board activity • Many papers document that independence increased and board size decreased post SOX → Our conclusion: SOX not only changed board structure, but also what boards do → This may potentially explain the puzzle of why banks with more independent boards were more likely to be bailed out during the crisis • This shift in activity may not have been value-enhancing…

  23. Was this a value-enhancing shift?

  24. What can we learn from monkeys?

  25. Adams (2011) “Corporate Governance”Table 1 Countries with Important Board-level Governance Policies Between 2007 and 2010

  26. Table 1 continued • 49 countries • 4 bank codes • 3 voluntary codes (not “comply or explain”) • 13 new codes • 29 updates to codes • 2 laws/regulations

  27. The Walker Review • U.K. government commissioned Sir David Walker to recommend measures to improve board-level governance at banks • The Walker Review (Walker, 2009, p. 41) points out that the boards of listed U.K. banks in 2007/8 were larger than those of other listed companies • Problematic because of "a widely-held view that the overall effectiveness of the board, outside a quite narrow range, tends to vary inversely with its size. That view would probably tend to converge around an "ideal" size of 10-12 members,... This view appears to be confirmed by behavioral studies of group size as described briefly..., attached as Annex 4."

  28. Annex 4

  29. References for annexes dealing with chairman role, appointments of directors, board and committee size

  30. We might worry about the fact that… • 14 out of 17 references are dated between 1948 and 2001 • No finance or economics literature cited in support of board size recommendation

  31. Reference 9: CO-EVOLUTION OF NEOCORTEX SIZE, GROUP SIZE AND LANGUAGE IN HUMANS

  32. Moreover… • “The predicted group size for humans is relatively large (compared to those for nonhuman primates)…” (p. 691) = 147.8 • “..it suggest that the intensity of grooming with a small number of “special friends” (or coalition partners) increases in proportion to increasing group size….we can use the relationship between group size and grooming time to predict the grooming time required to maintain cohesion in groups of the size predicted for modern humans.” (p. 687) = 42%

  33. We might worry about the fact that… • The number 8-12 does not seem to appear anywhere in the article • A paper based on research on nonhuman primates (i.e. MONKEYS) is the primary reference for the board size recommendation • No literature on banks cited in support of board size recommendation • Mean bank board size in Adams and Mehran 2010 is 18 (>>8-12), yet we find no negative impact of board size on bank performance

  34. Table 5-Adams and Mehran (2010) Fixed effect regressions of Tobin’s Q on board size plus controls using data on 35 banks 1965-1999

  35. Adams and Ragunathan (2011) “Banks boards and the crisis” • Calculate same measures of board activity as in “What do boards do?” • Publicly-traded banks w. proxies and Compustat data 2006-2009 (350, 325, 311, 296 observations, 274 banks all years) • Are big bank boards worse? • Can compare 2007 data to 2007 data on F500 • Can examine bank boards’ responses to the crisis

  36. Compare banks to F500 in 2007 • Yes, banks have bigger boards, but also… • More total activity • More per capita activity

  37. Compare banks to F500 in 2007 • Banks have more total activity but similar levels of committee activity → Banks delegate less

  38. Bank boards’ behaviour in the crisis • Absolute and per capita activity increased • Monitoring increased • Delegation decreased

  39. Are big bank boards bad? • Bank boards ARE bigger but they also appear to work harder than e.g. F500 boards • Even though they are bigger, they seem to have reacted to the crisis as one would have hoped they would • The decrease in delegation also seems intuitive

  40. Focus of many recent reforms • Committees! • These may increase delegation • SOX, NYSE and Nasdaq listing standards emphasized audit, compensation and nominating committees • The Walker Review suggests that banks form risk committees

  41. Closing thoughts

  42. The bad news • Easy to get caught up in media frenzy following the financial crisis • Pressure on politicians to do SOMETHING is intense • Hence: 49 countries implemented board-level governance reform between 2007 and 2010 • Problem: we don’t know as much as we would like about boards and the relationship between board structure and board activity • The measures of board activity we developed suggest that there may be no easy solution to supposed governance failures • Changing board structures may alter board activity

  43. The good news • There is a lot of interesting work to be done: • Regulators – why do they regulate without sufficient knowledge? • Bank boards – little work • Delegation – no (?) work • Committees – little work • Board data is getting better and better…

  44. We do not have to study monkeys to learn about boards!

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