Boards of Directors as an Endogenously Determined Institution Benjamin E. Hermalin Michael S. Weisbach Presented by: Michael Keefe January 18, 2006 FIN 7340 Corporate Theory IIDr. Nina Baranchuk

2 “The directors of [joint stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance [as owners]....Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company” Adam Smith -1776

3 Key Questions How do board characteristics or size affect profitability? How do board characteristics affect observable actions of the board? What factors affect the makeup of boards and how do they evolve over time?

4 Introduction – Survey Paper Definition – An economic institution that, in theory, helps to solve agency problems inherent in managing an organization. Formal theories limited Major Conflict – Between CEO and Board Significant empirical work, but little motivated by theory

5 Empirical Regularities Composition (insider/outsider ratio) does not imply profitability Number of directors is inversely related to performance Board actions are related to board decisions( insider/outsider ration is related toPoison Pills, Acquisitions, Compensation) Boards evolve relative to bargaining position of CEO

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7 Why are there boards? Regulation Driven – Boards pre-date regulations Larger than required by law Hypothesis Market solution to an agency problem Endogenously determined institution Provides contracts and incentives to management Shleifer and Vishny (1986) – Free-Rider problem alleviated by large outside shareholder. Power of shareholder works through board. Meissner (2000) – Side payments greater than gains for bad loans.

8 What do they do? Outside Director as a Monitor Fama (1980), Fama and Jensen(1983) – build reputation as expert monitor Kaplan and Reishus (1990) – build reputation as doesn’t make trouble Hermalin and Weisbach (1998) Board Specific Model Board decides to keep or fire CEO CEO ability linked to performance CEO prefers less independent board CEO bargaining power related to performance

9 Hermalin and Weisbach Predictions 1*Poor performance=>increase probability of replacement 2*Board independence => higher CEO turnover 3*Poor performance => more independent directors 4*CEO tenure=>less board independence 5*Accounting measures better predictor of tenure than stock performance 6Long Term persistence in corporate governance 7 CEO fired Private information => negative return Public Information => positive return 8CEO Salary Low Levels of Performance => limited affect to salary High Levels of Performance => affects salary * Strong empirical support

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11 Empirical Issues System Actions t+s = φCharacteristics + ε Profits t+s = βActions + η Characterisitcs t+s = μProfits + ξ Equilibrium or Out-of-Equilibrium? Methods Typically not jointly estimated Endogeneity handled with lags

12 Tobin's q Tobin's q = market value / asset value If the market value = asset value => Tobin's q= 1.0. If Tobin's q > 1.0, then market value > than the value of the company's recorded assets. Tobin's q reflects a number of variables, and in particular: The recorded assets of the company. Market sentiment, reflecting, for example, analysts' views of the prospects for the company, or speculation such as bid rumors. The intellectual capital of the company. Source: Wikepedia

13 Outside Directors and Performance Method: Contemporaneous Correlations with accounting measures and Tobin q Results: No Evidence supporting outside directors and performance Issue: Endogeneity – Poor performance leads to independent boards (Hermalin and Weisbach 1998) Method1: Lagged Performance as instrument for current performance Results1: No Evidence supporting outside directors and performance Method2: Rosenstein and Wyatt (1990) use event study for outside directors added to board Result2: Some evidence -.2% increase in return Benefit of Method: Controls for all firm specific effects

14 Board Size and Performance Jensen (1993) and Lipton and Lorsch (1992) suggest increase board size leads to agency problems Yermack (1996) – Negative Relation between board size and Tobin’s q Gertner and Kaplan (1996) Study: Board sizes of reverse leverage buyouts Method:board size smaller than comparable firm Equilibrium or out of equilibrium – Why hasn’t economic darwinism eliminated the unfit organizational form?

15 Board Size and Tasks (actions as a function of characteristics) CEO Turnover Findings: Robust relationship between turnover and performance Empirical issue – voluntary or non-voluntary Weisbach (1988)- Approach: interacts board composition with firm performance Finding: CEO turnover more sensitive to firm performance with outside directors. Robust to performance as measured by accounting or market measures CEO turnover with insider dominated boards not performance sensitive Yermack (1996) and Wu (2000) – Interact board size with performance and find smaller boards are more effective overseers of CEOs. Perry (2000) – Incentive pay also significant

16 Evidence from Takeover Market Shivdasani (1993) – Question: probability of takeover in a hostile bid? Finding: Additional directorships => lower probability Why? Cotter et al. (1997) Question: Relationship between return from hostile takeover and outside directors Result: Majority of outside directors=>20% increase in return. Harford (2000) – Documents pecunary interests of directors to resist a takeover. Byrd and Hickman (1992) Question: Relationship between return when acquiring Results: -1.33% abnormal return for entire sample -.07% abnormal return if 50% of directors outside -1.86% abnormal return if minority of directors outside

17 Poison Pills Effect can be argued both ways: Protect Management Increase bargaining position Brickley et al. (1994) Method: Split sample, analyzed market reaction Results: Poison Pill Announcements=> Decrease in price if majority inside directors Increase in price if majority of outside directors

18 Executive Compensation Core et al. (1999) Results: Weaker goverance => Higher CEO pay Measures: Outsiders appointed by CEO Directors over 69 Board Size Busy Directors (additional directorships) Interlocking Directors Yermack (1996) – pay for performance increases with small boards

19 Board Dynamics Changes in a firm’s characteristics =>changes in board composition Hermalin and Weisbach (1988) Poor Performance => more outside directors CEO succession imminent => more inside directors Firm leaves a product market => inside directors depart

20 CEO Power Struggle with Board Fundamentally Unobservable Approaches Hallock ( ) - Interlocking directorships Shivdasani and Yermack (1999) – board selection process (e.g. seperate nominating commitee) Baker and Gompers (2000) – CEO voting stake => board selection in IPO

21 Industry Studies Hospitals – non-profits and for-profit hospitals Brickley and Van Horn (2000) – can’t reject that both types maximize the same objective function Eldenberg et al. (2000) – find sensitivity to CEO turnover related to hospital performance, high admin costs, and high levels of uncompensated care vary by hospital type.

22 Future Research Directions Model inner workings of boards Test implications of models Study different type of boards – nonprofits, smaller firms, etc.