Trends in Corporate Governance

Benjamin E. Hermalin UC Berkeley

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.

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?

How to think about governance

Exhibit 1

Heuristic Illustration of the Distinction betw een Out-of-Equilibrium and Equilibrium Explanations for Certain Empirical Results

Out-of -Equilibrium Phenomenon

Boar d characteristic Firm performance or other firm attribute Boar d characteristic

Equilibrium Phenomenon
Firm performance or other firm attribute

Causal

Spurious correlation

Other factors (such as the CEO s previous performance)

Imported from Hermalin & Weisbach 2003

Ca us al

al us Ca

Thinking about governance

The role of directors:
Hire

a CEO. How you will monitor affects who you wish to hire. Monitor him (make assessments). Replace him if necessary.

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

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

Board monitors with intensity p; that is, acquires signal, y, about CEOs ability with probability p.

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 CEOs ability with probability p.

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 CEOs ability with probability p.

Earnings, x, realized.

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.

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 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.

Thinking about incumbent ability

distribution of true ability.

value (ability)

Thinking about incumbent ability

expected ability = distribution of true ability

value (ability)

Thinking about incumbent ability

expected ability = expected ability of replacement (which is normalized to 0) distribution of true ability

value (ability)

Thinking about incumbent ability

So, absent new information, want to

keep original CEO (his expected value greater than replacements)

Thinking about monitoring

distribution of true ability
expected ability expected ability of replacement bad signal good signal

replace incumbent

keep incumbent

Thinking about monitoring

highly likely

distribution of true ability

expected ability expected ability of replacement

not so likely

bad signal

good signal

replace incumbent

keep incumbent

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

Value of monitoring

Analysis
i. ii. iii.

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 boards diligence, .

Who gets monitored?

estimated ability of replacement

value (ability)

more value to monitoring red CEO than green CEO.

Who gets monitored?

estimated ability of replacement

value (ability)

more value to monitoring red CEO than green CEO.

Monitoring and who to hire

ability external candidate ability internal candidate

value (ability)

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

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.

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.

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

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

External CEOs more vulnerable

ability external candidate bigger left tail also means greater reason to monitor ability internal candidate estimated ability of replacement

value (ability)

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.

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 that influence boards perception if it monitors. This harder work will require compensation. Even if dont work harder, greater risk of losing job will require compensation.

Model: New timing

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

Board monitors with intensity p; that is, acquires signal, y+e, about CEOs ability with probability p.

Earnings, x+(e), realized. Surviving CEO gets benefit, b > 0.

Effort

Effort

distribution of signal

signal

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

signal

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

signal But in equilibrium boards not fooled it subtracts back expected effort when inferring ability

Effort
So even though not fooling anyone, CEO has to expend effort or look even worse!

signal But in equilibrium boards not fooled it subtracts back expected effort when inferring ability

Equilibrium of effort model

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: i. the lower the CEOs estimated ability, the more effort he expends in equilibrium (Avis); and ii. the more diligent is the board (i.e., the greater is ), the more effort the CEO expends in equilibrium.

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.

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.

Compensation without effort

i.

ii.

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.

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.

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.

Putting all the trends together

more effort

more independent boards (more outsiders)

more monitoring

more external CEOs

greater compensation

shorter average tenures

Whats 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

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., more independent boards) may yield bad trends (e.g., greater CEO compensation). From the perspective of theory, work remains.