Trends in Corporate Governance

1. Trends in Corporate Governance Benjamin E. Hermalin UC Berkeley

2. 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.

3. 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 imposed reform?

4. How to think about governance Imported from Hermalin & Weisbach 2003

5. How you will monitor affects who you wish to hire. Thinking about governance • The role of directors: • Hire a CEO. • Monitor him (make assessments). • Replace him if necessary.

6. Model: Timing Board hires new CEO. Internal (I) or External (E)

7. Model: Timing Board hires new CEO. Internal (I) or External (E) Board monitors with intensity p; that is, acquires signal, y, about CEO’s ability with probability p.

8. Model: Timing Board hires new CEO. Internal (I) or External (E) If signal acquired, Board makes decision to keep or fire incumbent CEO. Board monitors with intensity p; that is, acquires signal, y, about CEO’s ability with probability p.

9. Model: Timing Board hires new CEO. Internal (I) or External (E) If signal acquired, Board makes decision to keep or fire incumbent CEO. Board monitors with intensity p; that is, acquires signal, y, about CEO’s ability with probability p. Earnings, x, realized.

10. 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.

11. 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. • y -  and x -  are independently distributed.

12. Thinking about incumbent ability distribution of true ability. value (ability)

13. Thinking about incumbent ability expected ability =  distribution of true ability value (ability)

14. Thinking about incumbent ability expected ability =  expected ability of replacement (which is normalized to 0) distribution of true ability value (ability)

15. Thinking about incumbent ability • So, absent new information, want to keep original CEO (his expected value greater than replacement’s)

16. Thinking about monitoring distribution of true ability expected ability expected ability of replacement bad signal good signal replace incumbent keep incumbent

17. Thinking about monitoring highly likely distribution of true ability not so likely expected ability expected ability of replacement bad signal good signal replace incumbent keep incumbent

18. Benefit of monitoring expected ability expected ability of replacement distribution of true ability value (ability) on average, get rid of low ability CEOs on average, keep high ability CEOs

19. Value of monitoring

20. Analysis • Board chooses p to maximize (pV+(1-p)) – c(p). • Let P* be the solution. • Proposition 1: The intensity with which the board monitors the CEO, P*, is • decreasing with the prior estimate of his ability, ; • decreasing with the precision of the prior estimate, ; but • Increasing with the board’s diligence, .

21. Who gets monitored? estimated ability of replacement value (ability) more value to monitoring red CEO than green CEO.

22. Who gets monitored? estimated ability of replacement value (ability) more value to monitoring red CEO than green CEO.

23. Monitoring and who to hire ability external candidate ability internal candidate value (ability)

24. Monitoring and who to hire ability external candidate ability internal candidate estimated ability of replacement value (ability) monitoring means largely avoid these values monitoring means largely keep these values

25. Monitoring and who to hire • 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.

26. 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.

27. 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 …

28. External CEOs more vulnerable ability external candidate likely to draw bad signal and get fired ability internal candidate estimated ability of replacement value (ability) likely to draw bad signal and get fired

29. External CEOs more vulnerable ability external candidate ability internal candidate bigger left tail also means greater reason to monitor estimated ability of replacement value (ability)

30. Reasons external CEOs more vulnerable • More likely to have been hired by outsider-dominated board. • Regardless of board, greater uncertainty means monitoring more valuable, so monitored more. • Greater uncertainty  bigger left tail more likely to get bad signal.

31. Effort and compensation • Suppose that CEOs wish to keep their jobs. • Might make them work harder if effort can influence board’s perception if it monitors. • Equivalently, consume less perquisites if that influence board’s perception if it monitors. • This harder work will require compensation. • Even if don’t work harder, greater risk of losing job will require compensation.

32. Model: New timing If signal acquired, Board makes decision to keep or fire incumbent CEO. Board hires new CEO. Internal (I) or External (E) CEO expends effort, e, at cost k(e). 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.

33. Effort

34. Effort distribution of signal signal

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

36. Effort effort shifts the signal to the right, making CEO seem better if monitored signal But in equilibrium board’s not fooled — it subtracts back expected effort when inferring ability

37. Effort So even though not “fooling” anyone, CEO has to expend effort or look even worse! signal But in equilibrium board’s not fooled — it subtracts back expected effort when inferring ability

38. Equilibrium of effort model

39. 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: • the lower the CEO’s estimated ability, the more effort he expends in equilibrium (“Avis”); and • the more diligent is the board (i.e., the greater is ), the more effort the CEO expends in equilibrium.

40. 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.

41. 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.

42. Compensation without effort • 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: • Proposition 7: If the market for CEOs is homogenous, then • firms with more diligent boards pay more than firms with less diligent boards; and • as diligence increases over time across firms, average CEO compensation will also increase.

43. Time series and cross section • The last predictions might seem at odds with predictions of some who argue 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.

44. 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 the diligence 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, CEO compensation should co-vary positively with the diligence of the board.

45. Putting all the trends together more effort more independent boards (more outsiders) more monitoring more external CEOs greater compensation shorter average tenures

46. What’s been left out? • The bargaining between board & CEO (see Hermalin & Weisbach, AER 1998) • CEO life-cycle effects (less board independence as CEO tenure increases) board independence time trend firm path CEO tenure time

47. 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.