1. Commitment and Entrenchment in Corporate Governance Cremers, et al
Alan Schwartz
Comment
Stockholm: 6/10/16

2. 1. The convention is to attempt to answer the question whether defensive tactics (“DT”) increase firm value empirically. The dependent variable is Tobin’s Q; the RHS has particular tactics, or a basket of them, and the analyst runs cross-sectional and time series regressions with various controls.
2. Cremers, et al show (a) in the cross-section, DT reduce value; but (b) using a long-term panel with firm fixed effects, DT that shareholders approve, especially staggered boards, increase value but DT that target boards adopt unilaterally reduce firm value.

3. 3. The Cremer, et al results seem convincingly established so, staying within the genre, they win the argument. This is an important contribution.
4. This Comment will use their paper to raise some questions about the conventional way of thinking about DT/corporate governance issues. To anticipate, I suggest that more theory would be helpful.

4. Cross Section and ?
1. Optimal Choice: Assume: (a) A firm’s “type” is its ability to convert resources into profits; (b) Firms differ by type: firm A has a higher marginal return to resources invested than firm B: A is a “higher type firm”; (c) The firm with a higher marginal return to resources – with higher profits on average – has a higher marginal cost of agency: the firm has more to lose from being governed badly.
2. Then (d) There will be a positive correlation between firms’ returns and high governance scores; and (e) every firm is optimizing.

5. 3. Multiple Governance Techniques: (a) There are two techniques: α1 and α2; (b) these are substitutes; (c) firms are heterogenous, in the sense that the techniques are differentially costly for high and low type firms.
4. A high type firm sets α2 to zero; a low type firm sets α1 to zero. Again, each firm may be optimizing but running a regression such as
𝑄= 𝛾 0 + 𝛾 1 𝛼 1 + 𝛾 2 𝛼 2 +𝜀
won’t fully correct the problem. The coefficients will be biased downwards.

6. 5. In the first example, every firm is making optimal governance choices but some governance choices seem to create more value than others. In the second example, because optimizing firms use different techniques to achieve the same governance results, regressions understate the effect of each technique.
7. The Result: Hypothesis: There are no good or bad governance techniques; just (sometimes) good or bad firm choices. Cross-sectional results may not reject the hypothesis: Query: Does the panel fixed effects method fully correct for them?

7. Explaining the Results
1. There are three theories:
A. Boards (which in this Comment also includes managers) use DT to entrench themselves and consume private benefits;
B. Boards use unilateral DT to entrench themselves but shareholders consent to DT that protect boards from expropriation by bidders;
C. DT levels reflect privately efficient tradeoffs between maximizing bid prices (strong DT) and maximizing bid probabilities (low DT).
2. Note: The conventional approach cannot exclude theory C, which is an equilibrium story. See Gilson and Schwartz (2016).

8. 3. As between A and B, the paper argues that the data support Theory B
3. As between A and B, the paper argues that the data support Theory B. The reasoning apparently goes like this: Assume no DT. At t0 the stock price is p. The firm invests in a project, which it expects to return R at time T with probability β. The true stock price is p* = p + δT(βR). Investment is privately costly to the board.
4. Between t1 and T – 1, the board cannot credibly disclose the second term to the market: the project’s expected value. Therefore, the price likely remains at p.
5. An acquirer thus could buy the firm with a bid b < p* and fire the board, which then could not recover its cost (and any gains). Anticipating expropriation, the firm will not invest in the project.
6. And anticipating the board’s response, the shareholders vote for DT that permit the board, which knows the truth, to block exploitative low bids. The board will then invest.

9. 7. Question: Theory B does not explain how there could be exploitative bids. (a) With a pill, no such bid could succeed. (b) Without DT, there would be no demand for the firm.
8. Regarding (b), the shareholders require a premium to tender. Let the winning bid be b = (1 + λ)p. The bidder’s expected return is v – b. A bidder thus apparently must believe that the firm is worth (at least) its current price plus the expected value of its project. But there is no reason for the bidder to believe that the firm has new positive value projects when the market thinks the firm is worth only its current price.
9. Put another way, the assumption that δT(βR) is private information apparently precludes exploitative bids because potential acquirers have no reason to make them. Are bids random events?

10. 10. Further Questions: The Board only needs protection from exploitative bids between t0 and T-1: the “short run”. “In the long run, when projects materialize, there is no economic rationale to continue to protect firm insiders from shareholder discipline.”
11. Is there a mechanism to implement the governance transition from the short to the long run?
12. At time T, the board should declassify because either (a) the project has failed so the market price p is true and bids are welcome, or (b) the project has succeeded so the market price becomes p* and there cannot be exploitative bids.
13. Do shareholders declassify boards when they should? What should the shareholders do if the firm begins a new project? Will the market misvalue every project? Is the short run/long run distinction implementable?

11. 14. The paper offers a second reason for shareholders to protect boards. It may sometimes be optimal for firms to favor stakeholders at the possible short term expense of shareholders but to the long run value of the firm. The market may punish the firm for sharing wealth with stakeholders, however, so forward looking shareholders protect the board with DT.
15. Caution may be appropriate here because the conditions under which it is optimal for a firm to take stakeholders into account are strict: They include that the firm has monopoly power; the stakeholders are “close” – i.e., customers – and the firm can assign appropriate weights to stakeholder interests. But it may be impossible, on current wisdom, to assign appropriate weights without a market in stakeholder claims. For these conditions, see Magill, et al., “A Theory of the Stakeholder Corporation”, 83 Econometrica (2015).
16. Perhaps the stakeholder claim should be softened or the authors should do more theory.

12. 17. Finally, the paper uncovers an interesting puzzle: the DT effect on firm value appears systematically in the data only in the last 20 years. Before then, the data seem random.
18. The paper suggests an answer: the need for board protection has become more urgent as the clamor for shareholder power has become louder.
19. This may be right but is at odds with the conventional view that boards were more vulnerable to exploitative bids before the poison pill “revolution” – circa than after.
20. Hence, the puzzle may remain unless the paper makes more precise its view that exploitative bids pose a greater danger to firms in the last two decades than before.

13. Conclusion
1. This paper develops important and interesting empirical results. When it stays within the current conventions of discourse, it reverses the conventional wisdom: shareholder blessed DT can be good.
2. Viewed in a broader framework, this line of research raises theoretical questions. (a) If social welfare and firm welfare likely correspond inexactly, why study firm welfare? (b) Institutional investors and proxy advisors will not support majority insurgent director slates, so an insurgent must run two proxy contests with an ordinary board. Why do classified boards matter? (c) How can exploitative bids exist given the pill and that long term project predictions are private information?(d) What market equilibria do various DT levels support?
3. The paper develops interesting results but more importantly raises interesting questions.