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Ethics and Governance

CORPORATE
PERFORMANCE AND
DISCIPLINING BADLY
PERFORMING MANAGERS
Don Hickerson, University Fellow,
Lecturer, British University Vietnam,
Western University
Previous Lecture
In our last discussion, we:
1. Discussed the economic and political context which
has enabled global capitalism to rise
2. Reviewed the assumptions underlying the
taxonomies from the law and finance literature and
those from the VOC literature
3. Assessed the possible limitations of the various
taxonomies as well as the validity of their
predictions
4. Considered path dependence and distinguish
between the two types of path dependence.
Introduction
•Corporate governance devices or mechanisms
are arrangements that mitigate conflicts of
interests corporations may face.

•These conflicts of interests are those that may

arise between
•the providers of finance and managers,
•the shareholders and the stakeholders, and
•different types of shareholders (mainly the large
shareholder and the minority shareholders).
Introduction (cont.)
•Particular corporate governance mechanisms are
more likely to prevail in one corporate governance
system than in others.

•As we have discussed, these conflicts of interests is

also likely to vary across systems.

•Hence, in order to study the effectiveness of the

various corporate governance devices, one needs to
adopt one of the taxonomies of corporate
governance systems.
Introduction (cont.)
•We adopt the taxonomy by Franks and Mayer
which distinguishes between insider and outsider
systems.

•These systems are critical for two reasons:

1. It does not advocate the superiority of one
system
2. It provides a broad, yet convenient
framework to analyse the various corporate
governance devices.
Product Market Competition
•Competition in product and service markets may
reduce managerial slack across all corporate
governance systems.

•For example, a US manufacturer of household

appliances operates in the same global market as
manufacturers from other countries.

•If the US manufacturer suffers from weak corporate

governance, it may ultimately be driven out of the
market.
Product Market Competition (Cont.)
•Hermalin has developed a theoretical model
about the effects of competition on managerial
(agent) performance.

•He argues that competition has four distinct

effects on managerial performance
1. the income effect, (dangling a carrot)
2. the risk-adjustment effect, (risk or reward?)
3. the change-in-information effect, (what you know)
4. the effect on the value of managerial actions.
Product Market Competition (Cont.)
•However, generally it is still not clear whether
increased competition increases or decreases
managerial performance.

•While empirical evidence on the effect of

competition is still sparse, the studies that exist
suggest that
•competition forces managers to work harder, and
•it may even be a substitute for good corporate
governance.
04/21/24 10
Incentivising and Disciplining Managers
in the Insider and Outsider Systems
•The main mechanisms that are thought to keep
managers in check in the outsider system are
•the market for corporate control,
•dividend policy,
•the board of directors,
•institutional shareholders,
•shareholder activism,
•managerial remuneration, and
•managerial ownership.
The Market for Corporate Control
•The disciplinary role of the market for takeovers
was first proposed by Manne.
•Badly performing firms see their share price drop.
•They then become easy targets for hostile raiders
intend on changing the management, thereby
creating firm value.

•However, the empirical evidence does not

support Manne’s argument.
The Market for Corporate Control (Cont.)
•A US study by Schwert and a UK study by Franks and
Mayer investigate the pre-acquisition performance
of targets of hostile takeovers and targets of friendly
takeovers.

•Hostility is defined as the ‘target management’s

attitude toward the proposed takeover bid’.

•Neither the US nor the UK study finds any difference

in the pre-acquisition performance of both types of
targets.
The Market for Corporate Control (Cont.)
•However, the mere threat of a hostile takeover
may be enough to ensure that managers do not
shirk.

•These tend to be very rare outside the UK and the

USA.

•Hostile takeovers are an extreme and expensive

mechanism to correct managerial failure.
•Elon Musk acquiring Twitter is a good example
How Musk Leveraged TWITTER

04/21/24 15
Dividends and Dividend Policy
•Easterbrook and Rozeff were the first to
formalise the corporate governance role of
dividends.
•In Rozeff’s model, dividends reduce agency
costs by reducing the free cash flow.
•However, they also increase transaction costs
as higher dividends increase the need for costly
external financing.
•Hence, there is an optimal dividend payout
which minimises the sum of both costs.
Dividends and Dividend Policy (Cont.)
•Easterbrook also argues that by committing to
high dividends the free cash flow is kept to a
minimum and wastage by the managers is
reduced.
•In addition, the firm has to raise regularly outside
finance.
•Each time it does so it subjects itself to the
scrutiny of outsiders.
•If the managers have been performing badly,
then outside finance is unlikely to be made
available.
Dividends and Dividend Policy (Cont.)
•For dividends to be able to fulfil their disciplinary
role, they need to be sticky.

•Managers will need to carry on paying dividends

even if profits are down temporarily.

•The role of dividends is likely to be more

important in the outsider system given the lack of
shareholder monitoring.
Boards of Directors
•UK and US firms as well as firms from most other
countries have a single-tier board where both
executive and non-executive directors sit.
•A few countries, such as Germany and China, have
two separate boards, the so called two-tier board.
•The two-tier board consists of
•the supervisory board where the non-executives
(as well as maybe employee representatives) sit,
and
•the management board where the executives sit.
Boards of Directors (Cont.)
•There is an ongoing debate about whether a
single- or two-tier board is better.

•Some argue that having two boards ensures the

independence of the non-executives from the
executives.

•Others argue that having two boards prevents

the non-executives from being effective monitors
due to a lack of information.
Boards of Directors (Cont.)
•Is there a link between board structure and
financial performance?

•Do boards fire executives in the wake of poor

performance?

•What factors determine board changes?

•Should the roles of the chairman and the CEO be

separated?
What Makes A Good BoD

04/21/24 22
Is There a Link between Board Structure
and Financial Performance?
•The proportion of non-executives is normally used
as a measure of board independence.
•Boards that are dominated by non-executives are
likely to be more independent from the
management.
•However, there is little evidence in support of a
positive link between firm performance and board
independence.
•However, board composition may not be
exogenous, i.e. it may not be randomly
determined.
Is There a Link between Board Structure
and Financial Performance? (Cont.)
•For example, board composition may be
determined by past performance.
•If poor performance causes an increase in the
number of non-executives, then this would
explain why no link has been found between firm
performance and board independence.
•In contrast, there is conclusive evidence that large
boards are bad for firm performance.
•There is also evidence that interlocked
directorships cause collusion.
What Factors Determine Board Changes?
•Hermalin and Weisbach find that
•inside directors are more likely to be replaced by
outside directors in poorly performing companies:

•Inside directors normally replace retiring CEOs;

•When the CEO is replaced by an outsider, some
inside directors – possibly the losers in the contest
to the succession – leave the firm; and
•Firms leaving their product market replace their
inside directors with outside directors.
Should the Roles of the Chairman and
CEO Be Separated?
•There has been an ongoing debate as to whether
the roles of the chairman and the CEO should be
separated or whether duality is preferable.
•Proponents of duality base themselves on the
following three arguments
1. Duality ensures that there is strong leadership
2. Splitting the two roles may create tensions
between the CEO and chairman
3. Having a separate CEO and chairman makes it
difficult to designate a single spokesperson for
the company.
Should the Roles of the Chairman and
CEO Be Separated? (Cont.)
•Those opposed to duality argue that
1. Combining the two roles reduces board
independence and increase CEO entrenchment
2. It combines the role of monitoring the
executives and leading the executives in a
single person.
•In the USA, minds are still split as to whether duality
is good or bad.
•The empirical evidence on US firms is also as yet
inconclusive.
Should the Roles of the Chairman and
CEO Be Separated? (Cont.)

•In contrast, in the UK successive codes of best

practice in corporate governance have
recommended the separation of the two roles.

•In contrast to US evidence which is

inconclusive, evidence from UK firms seems to
suggest that duality has no effect on
performance.
04/21/24 29
Institutional Investors

•Institutional investors are the most important

types of shareholders in the UK and the USA as
well as a few other countries (e.g. the
Netherlands).

•However, the jury is still out as to whether

institutional investors monitor the management
of their investee firms.
Institutional Investors (Cont.)

•Some studies find positive effects of

institutional investors
•They have a positive effect on firm value
•They increase the performance sensitivity of
managerial pay
•They reduce the levels of managerial pay.
Institutional Investors (Cont.)

•Other studies find negative effects of

institutional investors
•They reduce firm value
•They have short-term horizons
•They increase the likelihood and severity of
financial misreporting.
Institutional Investors (Cont.)
•In the UK, successive codes of best practice in
corporate governance have urged institutional
investors to become more active.
•The 2001 Myners Report states that
•institutional investors “remain unnecessarily
reluctant to take an activist stance in relation to
corporate underperformance, even where this
would be in their clients’ financial interests”.
•A number of UK studies suggest that institutional
investors are mostly passive and prefer exit over
voice.
Institutional Investors (Cont.)
•Fidrmuc, Goergen and Renneboog study the price
reaction to insider trades in UK firms
•They expect that monitoring reduces the
information conveyed by insider trades.
•They find that the price reaction
•is highest for firms dominated by institutional
investors, and
•lowest for firms dominated by families and other
firms.
•They interpret this as evidence that institutional
investors are passive.
Shareholder Activism
•Shareholders may prefer to act behind the scenes
to address poor managerial performance in their
investee firms.

•However, they may use so called proxy contests

as a means of last resort if management remains
unresponsive.

•Proxy contests consist of soliciting the support of

other shareholders, via their votes, to bring about
change.
Shareholder Activism (Cont.)
•While shareholder-initiated proxy voting is
frequent in the USA and on the increase in the UK,
it is relatively rare in Continental Europe.

•Whereas proxy contests are relatively successful in

the USA, they are less successful in the UK and
Continental Europe.

•Managers of US firms are not legally bound to

implement shareholder proposals whereas they
have to in the UK and most of Continental Europe.
Shareholder Activism (Cont.)
•The stock market reaction to proxy contests is also
different between the USA and the UK-Continental
Europe

•In the USA, the stock price reaction is normally

positive

•In the UK and Continental Europe, it is negative

suggesting that the market interprets proxy
contests as a signal of shareholder discontent
rather than positive change.
04/21/24 38
Managerial Compensation
•One possible way of aligning the interests of
the managers with those of the shareholders is
managerial compensation.

•By making managerial compensation sensitive

to firm performance, managers should have the
right incentives to maximise shareholder value.
Is Managerial Compensation Sensitive to
Firm Performance?

•Pay sensitivity to performance has been

documented for a range of countries, including
the USA, the UK and Germany.

•However, other factors have also been shown

to have an effect
•firm size, and
•ownership and control.
Is Managerial Compensation Sensitive to
Firm Performance (Cont.)

•An important factor influencing managerial pay is

firm size.
•This suggests that executive directors benefit
from empire building via increased salaries.
•The empirical evidence suggests that this is a
concern
•Firms where managerial compensation is sensitive to
firm size are more likely to conduct acquisitions
•Managers experience a net increase in their
compensation despite the drop in post-acquisition stock
performance and sales
Is Managerial Compensation Sensitive to
Firm Performance (Cont.)

•Some argue that:

•managerial compensation is unlikely to address
corporate governance issues, and
•it is a corporate governance issue in itself as
directors of firms with poor governance are able
to set their own, excessive pay.
•Managerial pay has also been shown to be
asymmetric as:
•it increases with good luck,
•but not with bad luck.
Large Shareholder Monitoring
•Do large shareholders enhance firm value?
•Some theoretical research suggests that large
shareholders create value via their monitoring
which overcomes the free-rider problem.
•Generally, there is little empirical evidence that
large shareholders create value.

•However, this only seems to be the case when the

founder is the CEO or chairman.
Large Shareholder Monitoring (Cont.)
•In contrast, when one of the founder’s
descendents acts as the CEO there is normally
value destruction.
•Finally, evidence on East Asian countries by
Faccio et al. suggests that families expropriate the
minority shareholders by paying out dividends
that are too low.
•Other theoretical papers argue that large
shareholders may overmonitor the management.
Bank and Creditor Monitoring
•Debt on its own may be a powerful disciplinary
mechanism.

•As debt commits part of the firm’s cash flows to

its servicing, it reduces managerial discretion
and wastage.

•Firms with a large creditor may also benefit

from the monitoring by the latter.
Bank and Creditor Monitoring (Cont.)

•However, the evidence is as yet inconclusive as

to the effect of bank ownership and board
representation on firm performance.
04/21/24 47
Conclusions
•The relative importance of corporate governance
mechanisms varies across the insider and outsider
system.
•The effectiveness of the various corporate
governance mechanisms.
•The likely endogeneity of corporate governance
mechanisms.
•The interdependence of corporate governance
mechanisms.
Next Meeting
We will look at some of the following issues:
•The link between capital market development and
economic growth and which circumstances
particular types of industries are more likely to
thrive.
•Contrast bank financing with stock market
financing of corporations and assess the
importance of strong and efficient institutions in
promoting economic growth
•The impact of religion and trust on economic
growth.
Question?