The board of directors:
Lessons from the theory of the firm
Antoine Rebérioux (EconomiX)
Workshop ESNIE 2007, Cargese
25 may 2007
Broad definition of corporate governance
• O’Sullivan (2000): “ a system of CG shapes
who makes investment decisions in
corporations, what types of investments they
make, and how returns from investments are
distributed” (p.1)
• Attention paid to minority shareholders
• Two agency relationships:
– Majority shareholder / minority shareholders
– Executives officers (insiders) / minority
shareholders
2
Shareholder primacy
and the agency model
• Tirole (2006, p.16): “[the dominant view in
economics] is preoccupied with the ways in
which a corporation’s insiders can credibly
commit to return funds to outside investors”
3
Shareholder primacy
and the agency model
• Companies should be run in the sole interests of
shareholders
• CEOs are hired by shareholders, and should serve
their interest.
• They act as ‘agents’. This approach is usually
referred as ‘the agency model of CG’.
4
How to reduce agency costs?
• Direct intervention by shareholders through
legal devices:
– Shareholder activism
– Derivative suites
• Market mechanisms, operating through stock
price:
– Hostile Takeover
– Compensation package (share options schemes)
• Board of directors, that acts as an internal
mechanism.
5
Shareholder primacy and the role of
the board
Management literature stresses two different roles for
the board (see British Journal of Management 2005,
vol.16):
– ‘Control’ role, as a monitoring device
– ‘Strategic’ role
Agency model favours the monitoring role: the board
should monitor executives, to make sure that they
maximize the welfare of distant shareholders (see
Fama and Jensen, 1983).
6
Shareholder primacy and the
composition of the board
• Board should include only shareholder
representatives
• Independence of directors
• Three types of directors:
– Inside directors: current officers of the company
– Affiliated outside directors: former company officers,
relatives of company officers, persons who are likely to
have business relationships with the company.
– Independent directors
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Source: Gordon (2006), all publicly-traded US companies
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• Normative consensus on shareholder primacy
and the role of corporate law = «The end of
history in corporate law» (Hansmann and
Kraakman, 2001)
• + directors independence
= end of history in corporate governance?
• One challenger: the ‘team production model of
corporate law’, Blair and Stout (1999).
• Strange, disappointing results on independence
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• Whose interests should the corporation
serve?
• What is the content of directors fiduciary
duties ?
• How to allocate voting rights on the
board ?
10
Arguments in favor of shareholder value
• Argument of risk: “[…] voting rights are universally held
by shareholders, to the exclusion of creditors, managers and
other employees. […] The reason is that shareholders are
the residual claimants to the firm’s income. […] As the
residual claimants, shareholders have the appropriate
incentives […] to make discretionary decisions”
(Easterbrook and Fishel, 1993, pp. 67-68)
• “Incomplete contracts approach to corporate
governance” :
– Williamson (1984, 2006), Romano (1996) : shareholder
value
– Blair and Stout (1999), Zingales (1998, 2000):
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stakeholder value
Williamson (1984; 2006)
• Different constituencies might be residual
claimers.
• Need to investigate, in each particular case
(or transaction), the best (cost minimizing)
safeguard.
12
Williamson (1984; 2006)
A
p1
k=0
B
p
s=0
ˆ
p p
k >0
s>0
C
p̂
Figure 3 : schéma de contractualisation de Williamson [1985]
13
Williamson (1984; 2006)
2 reasons to explain k>0 in case of equity
capital:
– Shareholders are locked-in
– Investments to be financed are specific.
Then, need for a particular safeguard.
14
Williamson (1984; 2006)
The board:
– Should serve the interest of shareholders
– Should include only shareholder representatives
See Romano (1996): « Transaction cost
economics offers no analytical support for
expanding board representation to nonshareholder groups, and indeed, cautions
against such proposals » (p.293).
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Williamson (1984; 2006)
• Yet, not obvious that equity capital is
always used to finance specific
productive asset
• In the case of vertical integration, the
empirical link between asset specificity
and integration is strongly grounded, but
in the case of corporate finance?
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Zingales (1998)
• Voting rights should be allocated to
shareholders (locked-in argument)
• Yet the board should serve the interest of
the whole company, not solely of
shareholders
• Departure from shareholder value.
17
Zingales (1998)
• “Darkside of ownership” (Rajan and Zingales, 1998):
once a party controls an assets, then no incentive to
specialize this asset. Specialization (k) reduces the
outside option in case of negotiation, and then the
payoff.
• If specialization cannot be decided ex ante, through a
complete contract, then a solution is needed.
• Solution : Firm’s asset specialization should be
decided by the board of director, not in the interest of
shareholders but in the collective interest => extended
responsibility for directors.
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Blair and Stout (1999)
• Rely on the team production model put forward by
Alchian and Demsetz (1972).
• Team production:
– overall output (y) is greater than the sum of individual
contributions or investments due to the complementarities
of specific assets.
– The gains resulting from team production are nonseparable.
• When contracts are incomplete, stakeholders might be
reluctant to specialize their assets (hold up).
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Blair and Stout (1999)
• Solution: to delegate the control over the asset
to a neutral third party, with the objective to
act in the best interest of the team. Board of
director as a “mediating hierarch”, with
extended fiduciary duties.
• Yet voting rights on the board should be
allocated to shareholders (locked-in argument)
• Finally, B&S argue that the model is consistent
with the content of (US) corporate law.
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Blair and Stout (1999)
Two critics:
• Consistency between extended fiduciary
duties and allocation of voting rights to
shareholders. See the case of France.
• Is opportunism really more pervasive in
public companies, as compared to other
legal forms? (cf. Meese 2002)
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Debate is still open
• Some agreements:
– Analysis of the board of directors should rely on
efficiency concerns, based on the economics of
incentive.
– Corporate governance might play a role to induce
firm members to invest in firm specific capital.
22
The effects of board composition:
what is the impact of independence?
Bhagat and Black (1999)
Discrete tasks
– CEO replacement: when firms have poor observable
measures, independent boards are a bit quicker to replace
CEOs. Yet, when performance are reasonable, they are
slower.
– CEO compensation: The higher the proportion of
independents, the higher the compensation of CEO and
other officers.
– Baysinger, Kosnick and Turk (1991): the higher the
proportion of insiders, the higher the effort on R&D per
employee.
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Independence: impact on
performance
• Bhagat and Black (1999): “[m]ost studies find
little correlation, but a number of recent
studies report evidence of a negative
correlation between the proportion of
independent directors and firm performance-the exact opposite of conventional wisdom.”
(p.942).
24
Bhagat and Black (1999)
• Data set of 957 large US listed companies for 1991.
• Explained variables: economic return (ROA) and
stock price performance (Tobin’s Q), for 1985-1995.
• Explanatory variable = INDEP = % of independents –
% of insiders.
• Multivariate analysis: blockholding, firm size (sale),
board size (BSIZE), CEO ownership and independent
director ownership, sector.
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Bhagat and Black (1999)
Q91-93 = a + d1 INDEP + d2 BSIZE
+d3 log(SALE90) +d4 BLOCK + d5 CEOWNER
+d6 DIROWNER + q INDUSTRY
• Result 1: INDEP has a significant negative effect
on Tobin’s Q (and ROA)
• Result 2: Firms with ‘super majority board’
(INDEP>0,4) perform worse than the others
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Nuno Fernandes (2005)
• 58 companies listed on Euronext Lisbon between
2002-2004. One third with pure ‘insider’ board.
• Explained variable : Global annual pay to executives
(PAY)
• INDEP is the fraction of non-executive members.
• Control variables : annual stock return (RET), total
sales, standard deviation of stock returns within the
year (RISK), Book-to-Market ratio (inverse proxy for
growth opportunities), size of the board (BSIZE), a
dummy for index membership (DPSI20), a dummy
for industry.
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Nuno Fernandes (2005)
log(PAY) = a + d1 INDEP + d2 log(RET)
+ d3 log(SALE) + d4 RISK + d5 BTM
+ d6 BSIZE + d7 DPSI20 + q INDUSTRY
• Multivariate analysis in two subsets:
– Firms with no independent members
– Firms with at least one independent
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Nuno Fernandes (2005)
Result 1: in firms with no independent,
significant correlation between stock return
and CEO pay, but not in firms with
independent.
=>The relationship between CEO compensation
and firm performance is stronger in firms with no
independent board members.
Result 2: In firms with independent, INDEP is
positively correlated with the level of CEO
pay.
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How to explain those results?
• Diminishing marginal returns for independence
• Systemic effect rather than firm specific effect
• Are independent directors really independent ? (see
Bebchuk and Fried, 2004)?
• Trade off between independence and competence.
Independent have, by definition, less knowledge of the
firm than inside or affiliated outside.
Roberts, McNulty and Stiles (2005): ‘[…] the
advocacy by institutional investors, policy
advisors and the business media of greater nonexecutive independence may be too crude or even30
counter-productive’ (p. 19).
Conclusion
• Independence might be important, but it
should not be considered as an exclusive
criterion.
• Specific skills, knowlege of board members
might be important:
– As regard to the monitoring role
– As regard to the strategic role
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• Suggests an interesting research field:
efficiency of the board not only in incentive
terms, but also in cognitive terms
=> see e.g. Grandori 2004
• From this point of view, it might be efficient to
open the board to non-shareholder
constituencies.
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