International Corporate Governance: Incentivising Managers and Disciplining Badly Performing Managers

Slide 5.
International Corporate
Governance
Incentivising Managers and
Disciplining Badly Performing
Managers
Goergen, International Corporate Governance, 1st Edition Pearson Education Limited 2012
Slide 5.2
Lecture Aims
This lecture reviews the main devices or mechanisms
that are believed to ensure that managers run the
firm in the interests of the shareholders and punish
badly performing managers. The lecture assesses the
effectiveness and importance of these mechanisms
across various corporate governance systems. It
covers among others the following mechanisms: the
market for corporate control and hostile takeovers,
dividend policy, the board of directors, institutional
shareholders, shareholder activism, managerial
compensation, managerial ownership, monitoring by
large shareholders and creditors/banks.
Slide 5.3
Learning Outcomes
By the end of this lecture, you should be able to:
1. Assess the importance of various corporate
governance devices across the main systems of
corporate governance
2. Judge the efficiency of the various devices in terms of
preventing bad performance by the management
and/or disciplining bad managers
3. Critically evaluate the empirical research on the
importance and effectiveness of corporate
governance devices
4. Identify the gaps in the existing literature.
Slide 5.4
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).
Slide 5.5
Introduction (Continued)
Particular corporate governance mechanisms
are more likely to prevail in one corporate
governance system than in others.
The reason is that the prevalence of the above
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.
Slide 5.6
Introduction (Continued)
We adopt the taxonomy by Julian Franks and
Colin Mayer which distinguishes between
insider and outsider systems.
We adopt this taxonomy 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.
Slide 5.7
Product Market Competition

Competition in product and service markets
may reduce managerial slack across all
corporate governance systems.
For example, a French manufacturer of
household appliances operates in the same
global market as manufacturers from other
countries.
If the French manufacturer suffers from weak
corporate governance, it may ultimately be
driven out of the market.
Slide 5.8
Product Market Competition (Continued)

Benjamin 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
the
the
the
the
income effect,
risk-adjustment effect,
change-in-information effect, and
effect on the value of managerial actions.
Slide 5.9

The income consists of the following
expected income decreases with increased
competition,
but it also puts pressure on managers to perform
better by e.g. reducing their perks as well as other
costs.
The risk-adjustment effect concerns the fact

that competition changes the riskiness of the
various actions managers can take.
Slide 5.10

The change-in-information effect consists of the
following
Competition makes it easier for the principal to judge
the agents actions as there is now a (larger) peer
group of other companies
Competition also has an effect on managerial actions
by reducing the riskiness of both easy and hard actions
However, the decrease in riskiness may not necessarily
be uniform across both easy and hard actions
Hence, it is not clear whether managers will switch
from easy to hard actions or the converse.
Slide 5.11

Increased competition also changes the relative
value of managerial actions
By reducing the price cap, competition reduces the agents
expected income and hence his incentives to work hard
However, it also increases the value attached to cost
saving actions by the agent, making the latter work harder.
A priori, all of the above four effects have ambiguous

signs.
Hermalin shows that under certain conditions the
positive income effect will dominate and competition
will increase managerial performance.
Slide 5.12

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.
Slide 5.13
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 (= hostile
takeover?),
dividend policy,
the board of directors,
institutional shareholders,
shareholder activism,
(managerial remuneration, and)
(managerial ownership.)
Slide 5.14
Insider systems are characterised by

- concentrated control and complex ownership structures,
- managers being monitored and disciplined by the large
shareholder, and
- underdeveloped takeover and stock markets.
Outsider systems are characterised by

- dispersed ownership and control,
- well developed takeover and stock markets,
- managers being disciplined by hostile raiders
14
Slide 5.15
Incentivising and Disciplining Managers

in the Insider and Outsider Systems (Continued)
In the insider system, they are

monitoring by large shareholders, and
monitoring by banks and other large creditors.
Slide 5.16
The Market for Corporate Control

The disciplinary role of the market for
takeovers was first proposed by Henry 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 Mannes argument.
Slide 5.17

(Continued)
A US study by William Schwert and a UK study
by Julian Franks and Colin Mayer investigate the
pre-acquisition performance of targets of hostile
takeovers and targets of friendly takeovers.
Hostility is defined as the target managements
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.
Slide 5.18

(Continued)
However, the mere threat of a hostile takeover
may be enough to ensure that managers do
not shirk.
Still, hostile takeovers are an extreme and
expensive mechanism to correct managerial
failure.
They also tend to be very rare outside the UK
and the USA.
Slide 5.19
Dividends and Dividend Policy

Frank Easterbrook and Michael Rozeff were the
first to formalise the corporate governance role
of dividends.
In Rozeffs 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.
Slide 5.20
Dividends and Dividend Policy (Continued)

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.
Slide 5.21

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.
Slide 5.22

Marc Goergen, Luc Renneboog and Luis Correia da
Silva study the flexibility of German dividends
compared to UK and US dividends.
They find that, when profits are down temporarily,
German firms are much more willing to cut or omit
their dividends than UK and US firms.
German firms controlled by banks are even more
willing to cut or omit their dividends.
They conclude that large shareholder monitoring
acts as a substitute for dividends.
Slide 5.23
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 twotier 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.
Slide 5.24
Boards of Directors (Continued)

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.
Slide 5.25
Boards of Directors (Continued)

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?
Slide 5.26
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.
Slide 5.27
Is There a Link between Board Structure

and Financial Performance? (Continued)
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.
Slide 5.28
Do Boards Fire Executive Directors in

the Wake of Poor Performance?
There is consistent evidence of an increase in CEO
and board turnover in the wake of poor performance.
There is such evidence for both corporate
governance systems
the outsider system of the UK and the USA, as well as
the insider system of Germany and Japan.
However, board dismissals cannot be equated to

good corporate governance.
Managerial dismissals also only occur in cases of
extremely poor performance.
Slide 5.29
What Factors Determine Board Changes?

Benjamin Hermalin and Michael 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.
Slide 5.30
What Factors Determine Board Changes?

(Continued)
Steven Kaplan and Bernadette Minton find that
banks appoint representatives to the boards of
poorly performing Japanese firms that are part
of keiretsus.
Slide 5.31
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.
Slide 5.32

CEO Be Separated? (Continued)
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.
Slide 5.33

CEO Be Separated? (Continued)
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.
Slide 5.34
Institutional Investors (Continued)

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.
Slide 5.35

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.
Slide 5.36

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.
Slide 5.37

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.
Slide 5.38

Jana Fidrmuc, Marc Goergen and Luc 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.
Slide 5.39

However, evidence from case study research
by Marco Becht and others suggests that
institutional investors act behind the scenes.
Still, from an agency perspective it is not clear
why institutional investors should be the
panacea (wondermiddel) to all corporate
governance issues.
Slide 5.40
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.
Slide 5.41
Shareholder Activism (Continued)

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.
Nevertheless, managers of US firms are not
legally bound to implement shareholder
proposals whereas they have to in the UK and
most of Continental Europe.
Slide 5.42
Shareholder Activism (Continued)

The stock market reaction to proxy contests is
also different between the USA and the UKContinental 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.
Slide 5.43
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.
Slide 5.44
Managerial Compensation (Continued)

Managerial compensation may consist of
various components including
the base (or cash) compensation,
long-term incentive plans (LTIPs) such as stock
options and restricted stock grants,
benefits, and
perquisites.
Slide 5.45
Figure 1 Level and composition of CEO pay for 20
Slide 5.46
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.
Slide 5.47

Firm Performance (Continued)
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
Slide 5.48

Managerial compensation increases in line with
good post-acquisition performance, but is
insensitive to bad performance
In contrast, changes in compensation after large
capital expenditures are much smaller and also
more sensitive to poor performance
Managers seem to use the higher information
asymmetry surrounding acquisitions to boost their
compensation.
Slide 5.49

Another factor influencing managerial pay is
ownership and control
Widely held firms have been reported to have
higher managerial compensation than firms with
large shareholders
This suggests that large shareholder monitoring is a
substitute for managerial incentivising via
compensation packages.
Slide 5.50

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.
Slide 5.51

Lucian Bebchuk and Jesse Fried go one step
further.
They argue that managers are entirely selfserving and they maximise their pay subject
to a public outrage constraint.
Slide 5.52
How Should One Design Managerial

Compensation Contracts?
There is an extensive theoretical and empirical
literature on the design of managerial compensation.
Both stock ownership and stock options have their
advantages and drawbacks.
Stock ownership seems to make managers even
more risk averse given its downside.
Stock options address this issue as they have a
limited downside.
However, they also seem to exacerbate conflicts of
interests between managers and shareholders.
Slide 5.53
Managerial Ownership
The principalagent problem stems from the
separation of ownership and control.
One way of mitigating this problem is to give
managers shares in their firm.
However, managerial ownership may also
entrench managers.
Hence, there may be two sides to managerial
ownership.
Slide 5.54
Managerial Ownership (Continued)

Two types of studies analyse the link between
performance and managerial ownership
Those that assume ownership to be exogenous, i.e.
determined outside the system
Those that assume ownership to be endogenous,
i.e. ownership may depend on firm characteristics
such as past performance.
Slide 5.55
Studies Assuming Managerial Ownership

to be Exogenous
Morck, Shleifer and Vishny allow for a nonlinear relationship between managerial
ownership and firm value for the USA.
They find evidence of such a non-linear
relationship
Firm value rises with ownership in the 05% region
It then decreases in the 525% region to reach its
minimum value
It then increases again above 25% ownership, but
at a decreasing rate.
Slide 5.56

to be Exogenous (Continued)
There are three criticisms of this study
It has low explanatory power
Being a US study, there is low cross-sectional
variation of ownership
The study ignores non-managerial ownership.
Slide 5.57

Karen Wruck looks at 128 US firms with
large changes of ownership.
She includes non-managerial ownership.
She replicates the Morck et al. model
She finds the same effects for the 05% and 5
25% ranges
However, she only finds a positive effect in the
25100% range when she considers total
ownership.
Slide 5.58

John McConnell and Henri Servaes clearly
distinguish between managerial and nonmanagerial ownership.
They find a curvilinear link between firm value
and managerial ownership.
Firm value reaches its maximum in the 40
50% ownership range.
They also find a positive linear link between
firm value and institutional ownership.
Slide 5.59

Firm value
MSV
McC&S
Wruck
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
Managerial ownership
Slide 5.60

to be Endogenous (Continued)
These studies allow for current managerial
ownership to depend on past firm
characteristics, including firm performance.
These studies do not tend to find a link
between managerial ownership and firm
value.
Slide 5.61

Stacey Kole argues that if ownership influences
firm value, there should be corrective transfers.
She uses the same sample as Morck et al.
She finds the same effects for the 05% and 5
25% ranges, but no effect above 25%.
She then regresses performance for each of the
years 197785 on 1980 ownership.
She finds a link for the years 197780, but no
link for the years 198185.
Slide 5.62

She concludes that there should be a reversal
of causality as past performance seems to
have an effect on current managerial
ownership.
Slide 5.63

In addition to managerial ownership, Anup
Agrawal and Charles Knoeber look at the
following six governance mechanisms
institutional ownership,
large shareholder monitoring,
non-executives directors,
the managerial labour market,
the market for corporate control, and
monitoring by debtholders.
They employ a whole battery of econometric

techniques.
Slide 5.64

The only persistent effect they find is a negative
effect of non-executives on firm value.
They explain this negative effect by the fact that
non-executives frequently represent interest
groups other than the shareholders with objectives
other than shareholder value maximisation.
Charles Himmelberg, Glenn Hubbard and Darius
Palia allow for both ownership and firm
performance to be endogenous.
They do not find that current performance depends
on past ownership either.
Slide 5.65
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.
Nevertheless, there is some evidence from the USA
and Germany that family control creates value.
However, this only seems to be the case when the
founder is the CEO or chairman.
Slide 5.66
Large Shareholder Monitoring (Continued)

In contrast, when one of the founders
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.
Slide 5.67
Bank and Creditor Monitoring

Debt on its own may be a powerful disciplinary
mechanism.
As debt commits part of the firms 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.
Slide 5.68
Bank and Creditor Monitoring (Continued)

As the German system has been traditionally
qualified as being bank based, there is a body
studying the effects of German banks on firm
performance.
However, the evidence is as yet inconclusive
as to the effect of bank ownership and board
representation on firm performance.
Slide 5.69
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.

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Slide 5.

Product Market Competition

Product Market Competition (Continued)

Product Market Competition (Continued)

The risk-adjustment effect concerns the fact

Product Market Competition (Continued)

Product Market Competition (Continued)

A priori, all of the above four effects have ambiguous

Product Market Competition (Continued)

Incentivising and Disciplining Managers

The main mechanisms that are thought to keep

Insider systems are characterised by

Outsider systems are characterised by

Incentivising and Disciplining Managers

In the insider system, they are

The Market for Corporate Control

The Market for Corporate Control

The Market for Corporate Control

Dividends and Dividend Policy

Dividends and Dividend Policy (Continued)

Dividends and Dividend Policy (Continued)

Dividends and Dividend Policy (Continued)

Boards of Directors (Continued)

Boards of Directors (Continued)

Is There a Link between Board Structure

Is There a Link between Board Structure

Do Boards Fire Executive Directors in

However, board dismissals cannot be equated to

What Factors Determine Board Changes?

What Factors Determine Board Changes?

Should the Roles of the Chairman and

Should the Roles of the Chairman and

In the USA, minds are still split as to whether

Should the Roles of the Chairman and

Institutional Investors (Continued)

Institutional Investors (Continued)

Institutional Investors (Continued)

Institutional Investors (Continued)

A number of UK studies suggest that institutional

Institutional Investors (Continued)

They interpret this as evidence that institutional

Institutional Investors (Continued)

Shareholder Activism (Continued)

Shareholder Activism (Continued)

Managerial Compensation (Continued)

Figure 1 Level and composition of CEO pay for 20

Is Managerial Compensation Sensitive to

Is Managerial Compensation Sensitive to

Is Managerial Compensation Sensitive to

Is Managerial Compensation Sensitive to

Is Managerial Compensation Sensitive to

Managerial pay has also been shown to be

Is Managerial Compensation Sensitive to

How Should One Design Managerial

Managerial Ownership (Continued)

Studies Assuming Managerial Ownership

Studies Assuming Managerial Ownership

Studies Assuming Managerial Ownership

Studies Assuming Managerial Ownership

Studies Assuming Managerial Ownership

Studies Assuming Managerial Ownership

Studies Assuming Managerial Ownership

Studies Assuming Managerial Ownership