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.

Questions? How do these trends relate? What do they tell us about organization?

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

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 CEO’s ability with probability p.

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. If signal acquired, Board makes decision to keep or fire incumbent CEO.

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. If signal acquired, Board makes decision to keep or fire incumbent CEO. 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 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.

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

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

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

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

Thinking about monitoring distribution of true ability expected ability of replacement bad signalgood signal replace incumbentkeep incumbent

Thinking about monitoring distribution of true ability expected ability of replacement replace incumbentkeep incumbent highly likely not so likely bad signalgood signal

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

Analysis Proposition 1: The intensity with which the board monitors the CEO is i. decreasing with the prior estimate of his ability,  ; ii. decreasing with the precision of the prior estimate,  ; but iii. Increasing with the board’s diligence, .

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

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

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

Monitoring and who to hire value (ability) ability external candidate ability internal candidate monitoring means largely avoid these values estimated ability of replacement 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 value (ability) ability external candidate ability internal candidate likely to draw bad signal and get fired estimated ability of replacement likely to draw bad signal and get fired bigger left tail also means greater reason to monitor

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

Effort signal distribution of signal

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

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

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

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 CEO’s 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. 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.

Time series and cross section Last predictions might seem at odds with predictions of some 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. However, over time, as boards on average become more diligent, the trend should be toward an increase in CEO compensation

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

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.