Item #6 RESEARCH SEMINAR IN LAW, ECONOMICS, AND ORGANIZATION Professors Bebchuk, Hart, and Kaplow Monday, November 14, 2005 Pound 108, 12:30 p.m. CORPORATE GOVERNANCE IN CONTEXT By Bengt Holmstrom
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Item #6RESEARCH SEMINAR IN LAW, ECONOMICS, AND ORGANIZATIONProfessors Bebchuk, Hart, and Kaplow
Monday, November 14, 2005Pound 108, 12:30 p.m.
CORPORATE GOVERNANCE IN CONTEXT
By Bengt Holmstrom
0
Corporate Governance in Context
Bengt Holmstrom, MIT
Harvard Law School
November, 2005
Corporate Governance in Context
Bengt Holmstrom, MIT
Harvard Law School
November, 2005
1
Warren Buffett:
“In judging whether corporate America is serious about reforming itself, CEO pay remains the acid test. To date, the results aren’t encouraging”
Annual Letter to Shareholders 2004, Berkshire Hathaway
2
The Power Hypothesis
• CG system fundamentally flawed
• CEOs too powerful, boards too weak (Bebchuk-Fried, 2004)
• Correct power imbalance by giving shareholders intervention rights (Bebchuk, 2005)
• CG system fundamentally flawed
• CEOs too powerful, boards too weak (Bebchuk-Fried, 2004)
• Correct power imbalance by giving shareholders intervention rights (Bebchuk, 2005)
3
Power Hypothesis – two challenges
• Timing test:– why did system perform so well for so long?
– why did executive pay get out of hand in 1990s?
• Governance test:– do boards of closely held firms (family firms, buy-out firms) act very differently?
• Timing test:– why did system perform so well for so long?
– why did executive pay get out of hand in 1990s?
• Governance test:– do boards of closely held firms (family firms, buy-out firms) act very differently?
4
Corporate governance system –the two main tasks
• Decide who decides (selection problem)
• Make sure those in charge act responsibly (incentive problem)
• Decide who decides (selection problem)
• Make sure those in charge act responsibly (incentive problem)
5
Outline
• Historical context – rise of shareholder value
• Executive compensation –levels, structure and process
• Governance context – role of boards
• Reforms – selective job redesign
• Historical context – rise of shareholder value
• Executive compensation –levels, structure and process
• Governance context – role of boards
• Reforms – selective job redesign
6
Rise of Shareholder Value
7
All Acquisition Volume As % of beginning year total stock market value
1968-2001
0%
2%
4%
6%
8%
10%
12%
1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002
Bust-up Build-up
8
Two big restructuring waves
80s bust-up wave:– Hostile deals (takeovers)– Going private (over 100 Billion/yr)– All cash, high leverage (institutional money)– Targets: firms with excess cash
90s build-up wave:– Friendly deals – Publicly traded– Share swaps, stock options– Targets: consolidating industries
80s bust-up wave:– Hostile deals (takeovers)– Going private (over 100 Billion/yr)– All cash, high leverage (institutional money)– Targets: firms with excess cash
90s build-up wave:– Friendly deals – Publicly traded– Share swaps, stock options– Targets: consolidating industries
9
Why did this happen?
• Greed (Blair)• Return to healthy capitalism (Jensen)
….but WHY NOW?
• Need to understand past as well as present
• Greed (Blair)• Return to healthy capitalism (Jensen)
….but WHY NOW?
• Need to understand past as well as present
10
An alternative interpretation
• Deregulation, technological change created need for reallocation of capital
• Shareholders (market) got involved in reassigning decision rights (capital)
• Scandals a side-effect of system creating strong incentives for corporate restructuring
• On net a positive outcome – stock markets, profits soared, acquisitions paid off (?)
• Deregulation, technological change created need for reallocation of capital
• Shareholders (market) got involved in reassigning decision rights (capital)
• Scandals a side-effect of system creating strong incentives for corporate restructuring
• On net a positive outcome – stock markets, profits soared, acquisitions paid off (?)
11
Market Capitalization
0.000
2.000
4.000
6.000
8.000
10.000
12.000
14.000
16.000
18.000
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
Year
Billi
ons
12
Why did market influence increase?
• Organizational advantage in moving capital long distances (banks, VCs, LBOs, etc)
• Investors effective change agents–few vested interests (Hansman, Meyer-Milgrom-Roberts)
• Innovation– exploiting and exploring hard (Roberts)– “paying in dreams” (Amador-Landier)
• Organizational advantage in moving capital long distances (banks, VCs, LBOs, etc)
• Investors effective change agents–few vested interests (Hansman, Meyer-Milgrom-Roberts)
• Innovation– exploiting and exploring hard (Roberts)– “paying in dreams” (Amador-Landier)
13
Why do firms retain capital?
• Commitment to protect human capital (Shleifer-Summers, Hart-Moore)
• Commitment to limit short-termism (v Thadden)
• Utilizes knowledge effectively (Stein, Gromb-Scharfstein)
• Commitment to protect human capital (Shleifer-Summers, Hart-Moore)
• Commitment to limit short-termism (v Thadden)
• Utilizes knowledge effectively (Stein, Gromb-Scharfstein)
14
Executive Compensation
15
Executive compensation: the complaints
• Levels out of control (six fold increase in median pay 1980-2000; F-500 median 7.2 Mlnin 2002)
• Windfall gains (60% from general market; no relative performance evaluation)
• Distorted incentives (earnings management; eg. Bergstresser-Philippon)
• Levels out of control (six fold increase in median pay 1980-2000; F-500 median 7.2 Mlnin 2002)
• Windfall gains (60% from general market; no relative performance evaluation)
• Distorted incentives (earnings management; eg. Bergstresser-Philippon)
16
CEO Pay Development 1980-2001
$0
$1
$2
$3
$4
$5
$6
$7
$8
$9
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
Med
ian
CEO
Pay
($ m
illio
ns)
Salary & Bonus Equity-based Pay
60%
58%
54%
49%
43%
40%
37%
32%86%92%
96%95%90%
93%99%
63%
66%
Hall, HBS WP 2003
17
A family firm without agency problems
• We benchmark– salary, bonuses, options• We pay above average• We do not use RPE• We ask before appointing new directors
Why?
• We want to avoid bargaining• We do not want to be over-bearing• We want an empowered CEO
• We benchmark– salary, bonuses, options• We pay above average• We do not use RPE• We ask before appointing new directors
Why?
• We want to avoid bargaining• We do not want to be over-bearing• We want an empowered CEO
18
Why did levels escalate in 1990?
• Increased value of executive talent (Hubbard-Himmelberg, Murphy-Zabojnik)
• Huge bargaining wedge• Equilibrium determined by peer comparison• Rise of shareholder value fuelled use of
options
• Public attention did not help• Boards may not have understood true cost
(Hall-Murphy)
• Increased value of executive talent (Hubbard-Himmelberg, Murphy-Zabojnik)
• Huge bargaining wedge• Equilibrium determined by peer comparison• Rise of shareholder value fuelled use of
options
• Public attention did not help• Boards may not have understood true cost
(Hall-Murphy)
19
Why options?
• More bang for the buck• Good at inducing value increasing
transactions
……but
• Incentives sensitive to share price• Reissuing makes dynamic cost opaque• Curse of capitalization/overvaluation and
earnings manipulation• Pressure to grant options broadly, very
costly
• More bang for the buck• Good at inducing value increasing
transactions
……but
• Incentives sensitive to share price• Reissuing makes dynamic cost opaque• Curse of capitalization/overvaluation and
earnings manipulation• Pressure to grant options broadly, very
costly
20
Incentive sensitivity
Incentive strength
3
Three options
1.5
1 One share
Stock price100
21
Some other issues
• What do you want to achieve?
• Partial transparency – leads to stealth compensation (Singh)
• Why so little relative performance evaluation? (LBOs, family firms)
• Implicit incentives – pros and cons of short-termism
• What do you want to achieve?
• Partial transparency – leads to stealth compensation (Singh)
• Why so little relative performance evaluation? (LBOs, family firms)
• Implicit incentives – pros and cons of short-termism
22
Improving compensation
• Structure:– Restricted stock (robust, transparent)– Longer horizons, fixed cash-out dates– Smaller, more frequent awards (partial indexation)
–Avoid performance plans
• Level: – More not less benchmarking
External credibility limits designs (ISS)
• Structure:– Restricted stock (robust, transparent)– Longer horizons, fixed cash-out dates– Smaller, more frequent awards (partial indexation)
–Avoid performance plans
• Level: – More not less benchmarking
External credibility limits designs (ISS)
23
The Role of Boards
24
Why do we have boards?
• Bebchuk (2005): treats executives and board as one body – “management”
• Where’s the role for boards?
• Three economic reasons:– Economizes on information acquisition– Protects confidentiality of information– Acts as intermediary (buffer) between
shareholders and management
• Bebchuk (2005): treats executives and board as one body – “management”
• Where’s the role for boards?
• Three economic reasons:– Economizes on information acquisition– Protects confidentiality of information– Acts as intermediary (buffer) between
shareholders and management
25
Bebchuk and Fried (p 203):
“..the [directors] would still be subject to social and psychological factors inducing them to remain on good terms with the CEO. As long as directors are supposed to act collegially and feel like part of a team of which the CEO is for many purposes the leader, they will feel more comfortable accommodating his or her wishes than opposing them.”
26
What do boards (try to) do?
• Evaluate (main task): Is the right team in charge? Does strategy make sense? Is capital efficiently used?
• Monitor (side task): Oversee conduct
• Auditors check fraud• Management designs strategy
• What is the objective of boards?
• Evaluate (main task): Is the right team in charge? Does strategy make sense? Is capital efficiently used?
• Monitor (side task): Oversee conduct
• Auditors check fraud• Management designs strategy
• What is the objective of boards?
27
Board challenges:
Challenge # 1: Challenge # 1:
Maintaining credibility with managementImpacts access to crucial, tacit information
Challenge # 2:
Maintaining credibility with shareholdersImpacts ability to use expert information
Maintaining credibility with managementImpacts access to crucial, tacit information
Challenge # 2:
Maintaining credibility with shareholdersImpacts ability to use expert information
28
Two Communication Problems
CEO
Board
Intervention
Intervention
Communication
Share-holdersCommunication
29
Management-Board Game (Crawford-Sobel, Adams-Ferreira)
• Management wants a (reasonably) informed board:– needs board understanding in times of crises– values advice
….but
• Worried about excessive intervention. Over-bearing board kills information flow (family firms, Coca-Cola)
• Management wants a (reasonably) informed board:– needs board understanding in times of crises– values advice
….but
• Worried about excessive intervention. Over-bearing board kills information flow (family firms, Coca-Cola)
30
On entrenchment (Hermalin-Weisbach)
• Management that does well gains power• Leads to consolidation of power• This is an efficient commitment mechanism
Additional prediction:
• Dismissal has positive stock price effect it accords with public perception and negative if it goes against public perception
• Management that does well gains power• Leads to consolidation of power• This is an efficient commitment mechanism
Additional prediction:
• Dismissal has positive stock price effect it accords with public perception and negative if it goes against public perception
31
Board-Shareholder Game
• Reputation concerns can lead to limited use of information (Holmstrom, Ely-Valimaki)
• Shareholder pressure leads to short-termism(Stein), biased behavior (Aghion-Stein)
…therefore
• Entrenched board can be valuable (Fisman-Khurana and Rhodes-Kropf)
• Biased supervisor can be valuable (Dessein)
• Reputation concerns can lead to limited use of information (Holmstrom, Ely-Valimaki)
• Shareholder pressure leads to short-termism(Stein), biased behavior (Aghion-Stein)
…therefore
• Entrenched board can be valuable (Fisman-Khurana and Rhodes-Kropf)
• Biased supervisor can be valuable (Dessein)
32
One way to think about reforms – how do they affect information games?• Mandatory rules can facilitate board access to
information (eg non-executive sessions)
• Shareholder intervention rights can suppress board’s use of expert information
• Selective job re-design -- eg external evaluation of compensation plans (ISS versus GACP)
• Mandatory rules can facilitate board access to information (eg non-executive sessions)
• Shareholder intervention rights can suppress board’s use of expert information
• Selective job re-design -- eg external evaluation of compensation plans (ISS versus GACP)
33
Concluding observations
• Organizational experiments (Enron) may fail at times; that’s okay
• Public outrage part of overall corporate governance system
• Is advocacy a good social system for reforming corporate governance?
• Organizational experiments (Enron) may fail at times; that’s okay
• Public outrage part of overall corporate governance system
• Is advocacy a good social system for reforming corporate governance?
35
Going private volumeAs fraction of total stock market value
2.50%2.50%
2.00%2.00%
1.50%1.50%
1.00%1.00%
0.50%0.50%
197919790.00%0.00%
19811981 19831983 19851985 19871987 19891989 19911991 19931993 19951995
36
U.S. Private Equity (fundraising)
0
25
50
75
100
125
150
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
OtherBuyoutVenture
Billions of 2002 $s Source: Venture Economics and Asset Alternatives.
37
All Employee Option Grants 1992-2002
Hall-Murphy, 2003
38
Pay to Performance: The Link Between CEO Wealth and Shareholder Value Since 1980
0
2
4
6
8
10
12
80 82 84 86 88 90 92 94 96 98
YearThe analysis controls for the changing composition of firm size over time. Thus, these estimates show the pay to performance link for a similarly
sized company over time, in this case a company w ith a market value of $ 1 billion.
How
CEO
Wea
lth c
hang
es p
er $
1000
cha
nge
in s
hare
hold
er w
ealth
$0
$200,000
$400,000
$600,000
$800,000
$1,000,000
$1,200,000
How
CEO
Wea
lth c
hang
es p
er 1
0 pe
rcen
t cha
nge
in c
ompa
ny m
arke
t va
lue
$1000 change 10 percent change
39
Adams-Ferreira (adapted):• Two periods: x1 = a + ε1 and x2 = a + s + ε2
a -- management ability; estimate e0 = E(a)
• Stage 1: Public observes x1 and board updates to e1 = E(a| x1)• Stage 2: Mgt learns s; Communicates r: {s ≥ r} verifiably to
board
• Stage 3: Board updates to e2 = E(x2| x1,r, m), where m is additional private signal about a + ε2. Board replaces management if e0 ≥ e2
• Stage 4: Management gets private benefit from continuing and from perks. Board maximizes profits and can limit perks more effectively, the higher is r.
• Two periods: x1 = a + ε1 and x2 = a + s + ε2 a -- management ability; estimate e0 = E(a)
• Stage 1: Public observes x1 and board updates to e1 = E(a| x1)• Stage 2: Mgt learns s; Communicates r: {s ≥ r} verifiably to
board
• Stage 3: Board updates to e2 = E(x2| x1,r, m), where m is additional private signal about a + ε2. Board replaces management if e0 ≥ e2
• Stage 4: Management gets private benefit from continuing and from perks. Board maximizes profits and can limit perks more effectively, the higher is r.
40
Hermalin-Weisbach:
• Two periods: xt = a + εt ; a = management value• Stage 1: board observes x1 and updates a-estimate• Stage 2: Negotiation over wage and filling of board
vacancies• Stage 3: Board observes additional information about
management ability with probability p (depends on monitoring intensity)
• Stage 4: Board updates a-estimate (if it got info) and decides on replacing management
• Stage 5: x2 realized
• Two periods: xt = a + εt ; a = management value• Stage 1: board observes x1 and updates a-estimate• Stage 2: Negotiation over wage and filling of board
vacancies• Stage 3: Board observes additional information about
management ability with probability p (depends on monitoring intensity)
• Stage 4: Board updates a-estimate (if it got info) and decides on replacing management
• Stage 5: x2 realized
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