The board of directors: Lessons from the theory of the firm Antoine Rebérioux (EconomiX) Workshop ESNIE 2007, Cargese 25 may 2007

2 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

3 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”

4 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’.

5 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. How to reduce agency costs?

6 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).

7 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

8 Source: Gordon (2006), all publicly-traded US companies

9 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

10 Whose interests should the corporation serve? What is the content of directors fiduciary duties ? How to allocate voting rights on the board ?

11 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 ) “Incomplete contracts approach to corporate governance” : –Williamson (1984, 2006), Romano (1996) : shareholder value –Blair and Stout (1999), Zingales (1998, 2000): stakeholder value

12 Williamson (1984; 2006) Different constituencies might be residual claimers. Need to investigate, in each particular case (or transaction), the best (cost minimizing) safeguard.

13 Williamson (1984; 2006)

14 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.

15 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 non- shareholder groups, and indeed, cautions against such proposals » (p.293).

16 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?

17 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.

18 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.

19 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).

20 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.

21 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)

22 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.

23 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.

24 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).

25 Bhagat and Black (1999) Data set of 957 large US listed companies for Explained variables: economic return (ROA) and stock price performance (Tobin’s Q), for Explanatory variable = INDEP = % of independents – % of insiders. Multivariate analysis: blockholding, firm size (sale), board size (BSIZE), CEO ownership and independent director ownership, sector.

26 Bhagat and Black (1999) Q = a + d 1 INDEP + d 2 BSIZE +d 3 log(SALE90) +d 4 BLOCK + d 5 CEOWNER +d 6 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

27 Nuno Fernandes (2005) 58 companies listed on Euronext Lisbon between 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.

28 Nuno Fernandes (2005) log(PAY) = a + d 1 INDEP + d 2 log(RET) + d 3 log(SALE) + d 4 RISK + d 5 BTM + d 6 BSIZE + d 7 DPSI20 + q INDUSTRY Multivariate analysis in two subsets: –Firms with no independent members –Firms with at least one independent

29 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.

30 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 non- executive independence may be too crude or even counter-productive’ (p. 19).

31 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

32 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.