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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;
that is, acquiressignal, y, about
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;
that is, acquiressignal, y, about
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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Thinking about incumbent ability
value(ability)
distribution of true
ability
expected ability =
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Thinking about incumbent ability
value(ability)
distribution of true
ability
expected ability = expected ability
ofreplacement(which is
normalized
to 0)
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Thinking about incumbent ability
So, absentnew information, want to
keep original CEO (his expected value
greater than replacements)
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Thinking about monitoring
distribution of true
ability
expected ability
expected ability
ofreplacement
bad signal good signal
replace incumbent keep incumbent
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Thinking about monitoring
distribution of true
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)
distribution of true
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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Monitoring and who to hire
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 and who to hire
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.