Mba1034 cg law ethics week 8 leadership 2013

LEADERSHIP, GOVERNANCE

ANDETHICS

Stephen Ong, BSc(Hons) Econs (LSE), MBA International Business(Bradford)

Visiting Fellow, Birmingham City UniversityVisiting Professor, Shenzhen University

MBA1034 GOVERNANCE, LAW & ETHICS

• Discussion: Corporate Social Performance

1

• Leadership, CEO Succession and Corporate Control

2

• Case Discussion: Walmart

• Video : Walmart3

Today’s Overview

1. Open Discussion

• Foo Nin Ho, Wang Hui-Ming Deanna and Vitell, Scott J.(2012) A Global Analysis of Corporate Social Performance: The Effects of Cultural and Geographic Environments, Journal of Business Ethics, 2012:107: pp.423–433

CASE DISCUSSION : WALMART

Cases - Wal-mart: Nonmarket Pressure and Reputation Risk : A New Nonmarket Strategy

• In 2004 Wal-Mart decided to reduce the nonmarket pressure it faced by establishing a “gentler” image with respect to its competition

• To deal with grassroots critics, Wal-Mart opened eight community relations offices in various locations

• In April 2005, Wal-Mart held its first-ever media conference

• Wal-Mart also ran ads in Asian languages on Chinese, Vietnamese, and Filipino television stations

• Wal-Mart began to work with Conservation International and the Natural Resources Defense Council on environmental initiatives

Cases - Wal-mart: Nonmarket Pressure and Reputation Risk (B): A New Nonmarket Strategy

• In 2005, Wal-Mart : – Announced a $35 million, 10-year Acres for America

program to offset the nearly 140,000 acres that its current stores occupied plus its planned expansion over the next 10 years

– Announced a major environmental initiative focused on reducing energy use

– Established a $25 million private equity fund to support businesses owned by women

– Held a conference in which economists presented analyses of its economic impact

– Formed the “Working Families for Wal-Mart” to counter the company’s critics

2.LEADERSHIP

Management & Control• 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 effectiveness and importance of these mechanisms across various corporate governance systems. – 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.

Learning OutcomesBy 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.

• 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).

Introduction

• 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.

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 reasons1. It does not advocate the superiority of

one system2. It provides a broad, yet convenient

framework to analyse the various corporate governance devices.

Introduction (Continued)

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.

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

• 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.

Product Market Competition (Continued)

• The change-in-information effect consists of the following– Competition makes it easier for the principal to

judge the agent’s 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.


• Increased competition also changes the relative value of managerial actions– By reducing the price cap, competition reduces the agent’s

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.


• 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.


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,– dividend policy,– the board of directors,– institutional shareholders,– shareholder activism,– managerial remuneration, and– managerial ownership.

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.

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 Manne’s argument.

The Market for Corporate Control (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 management’s 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.

• 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.

The Market for Corporate Control (Continued)

Dividends and Dividend Policy• Frank Easterbrook and Michael Rozeff were

the first to formalise the corporate governance role of dividends.

• In Rozeff’s 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.

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.

• 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.

Dividends and Dividend Policy (Continued)

• 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.

Dividends and Dividend Policy (Continued)

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 two-tier 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.

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.

• 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?

Boards of Directors (Continued)

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.

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.

Do Boards Fire Executive Directors inthe 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.

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.

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.

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 arguments1. Duality ensures that there is strong leadership2. Splitting the two roles may create tensions

between the CEO and chairman3. Having a separate CEO and chairman makes it difficult

to designate a single spokesperson for the company.

Should the Roles of the Chairman and CEO Be Separated? (Continued)

• Those opposed to duality argue that1. Combining the two roles reduces board

independence and increase CEO entrenchment2. 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.

• 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.

Should the Roles of the Chairman and

CEO Be Separated? (Continued)

Institutional Investors• 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.

• 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.

Institutional Investors (Continued)

• 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.


• 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.


• 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.


• 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 to all corporate governance issues.


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.

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.

• The stock market reaction to proxy contests is also different between the USA and the UK-Continental 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.

Shareholder Activism (Continued)

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.

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.

Figure 1 – Level and composition of CEO pay for 2005

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Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012

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.

Is Managerial Compensation Sensitive to 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

– 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.

Is Managerial Compensation Sensitive to

Firm Performance (Continued)

• 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.



• 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.



Lucian Bebchuk and Jesse Fried go one step further.• They argue that managers are entirely self-

serving and they maximise their pay subject to a public outrage constraint.



How Should One Design ManagerialCompensation 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.

Managerial Ownership• The principal–agent 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.

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.

Studies Assuming Managerial Ownership to be Exogenous• Morck, Shleifer and Vishny allow for a non-linear

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 0–5% region– It then decreases in the 5–25% region to reach its

minimum value– It then increases again above 25% ownership, but at a

decreasing rate.

Studies Assuming Managerial Ownership 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.


• 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 0–5% and 5–25% ranges

– However, she only finds a positive effect in the 25–100% range when she considers total ownership.


• John McConnell and Henri Servaes clearly distinguish between managerial and non-managerial 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.


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Studies Assuming Managerial Ownership 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.


• 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 0–5% and 5–25%

ranges, but no effect above 25%.• She then regresses performance for each of the

years 1977–85 on 1980 ownership.• She finds a link for the years 1977–80, but no link

for the years 1981–85.


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


• 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.


• 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.

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.

Large Shareholder Monitoring (Continued)

• In contrast, when one of the founder’s 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.

Bank and Creditor Monitoring

• Debt on its own may be a powerful disciplinary mechanism.

• As debt commits part of the firm’s 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.

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.

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.

Core Readings• Solomon, Jill (2010) Corporate Governance and

Accountability 3rd Edition, Wiley, UK. Ch.4-5• Goergen, Marc (2012) International Corporate

Governance, Pearson. Ch.5, 9-10• Larker & Tayan (2011) Ch.3-5,12• Monks & Minow (2011) Ch.2 & 3• Johnson, Scholes & Whittington(2008) Ch.4• CIMA - Performance Strategy: Study Text (2011) BPP

Learning Media Ltd. Part B : 5-6• Baron, David P.(2013) Business and its environment, 7th

Edition, Pearson

Additional Readings (1)• Byrd, J. W. and Hickman, K. A. (1992) ‘Do outside directors monitor

managers?’, Journal of Financial Economics, 32, 195–221.• Donaldson, L. and Davies, J. H. (1994) ‘Boards and company

performance—Research challenges the conventional wisdom’, Corporate Governance: An International Review, 2(3), July, 151–160.

• Peel, M. and O’Donnell, E. (1995) ‘Board structure, corporate performance and auditor independence’, Corporate Governance: An International Review, 3(4), October, 207–217.

• Milliken, F. J. and L. L. Martins (1996) "Searching for Common Threads: Understanding the Multiple Effects of Diversity in Organisational Groups", Academy of Management Review, 21, pp.402-433.

• Core, J. E., Holthausen, R. W. and Larcker, D. F. (1999) ‘Corporate governance, chief executive officer compensation, and firm performance’, Journal of Financial Economics, 51, 371–406.

• Thompson, S. (2005) "The Impact of Corporate Governance Reforms on the Remuneration of Executives in the UK", Corporate Governance: An International Review, Vol.13, No.1, January, pp.19-25.

Additional Readings (2)• Berle, A. and Means, G. (1932) The Modern Corporation and Private Property, New York.• Monks, R. A. G. (1994) ‘Tomorrow’s corporation’, Corporate Governance: An International Review, 2(3), July, 125–

130.• Nesbitt, S. L. (1994) ‘Long-term rewards from shareholder activism: A study of the “CalPERS effect”’, Journal of

Applied Corporate Finance, 6, 75–80.• Stapledon, G. P. (1995) ‘Exercise of voting rights by institutional shareholders in the UK’, Corporate Governance: An

International Review, 3(3), 144–155.• Stapledon, G. P. (1996) Institutional Shareholders and Corporate Governance, Clarendon Press, Oxford.• Smith, M. P. (1996) ‘Shareholder activism by institutional investors: Evidence from CalPERS’, Journal of Finance,

51(1), March, 227–252.• Agrawal, A. and Knoeber, C. R. (1996) ‘Firm performance and mechanisms to control agency problems between

managers and shareholders’, Journal of Financial and Quantitative Analysis, 31(3), September, 377–397.• Mallin, C. A. (1996) ‘The Voting Framework: A Comparative Study of Voting Behaviour of Institutional Investors in

the US and the UK’, Corporate Governance: An International Review, 4(2), April, 107–122.• Solomon, A. and Solomon, J. F. (1999) ‘Empirical evidence of long-termism and shareholder activism in UK unit

trusts’, Corporate Governance: An International Review, 7(3), July, 288–300.• Faccio, M. and Lasfer, M. A. (2000) ‘Do occupational pension funds monitor companies in which they hold large

stakes?’, Journal of Corporate Finance, 6, 71–110.• Solomon, J. F., Solomon, A., Joseph, N. L. and Norton, S. D. (2000) ‘Institutional investors’ views on corporate

governance reform: Policy recommendations for the 21st century’, Corporate Governance: An International Review, 8(3), July, 217–226.

• Mallin, C. A. (2001) ‘Institutional investors and voting practices: An international comparison’, Corporate Governance: An International Review, 9(2), April, 118–126.

• Myners (2001) Institutional Investment in the United Kingdom: A Review (The Myners Report), London.• MacKenzie, C. (2004) "Don't Stop Rattling Those Boardroom Chains: Corporate Activists Are Key to Maintaining

Shareholder Returns", Financial Times, 10th May, p.6.• National Association of Pension Funds (NAPF) (2005) Pension Scheme Governance - Fit for the 21st Century, NAPF

Discussion Paper, July.

Next Week’s Ideas for Discussion

• Petit, Vale´rie and Bollaert, Helen (2012) Flying Too Close to the Sun? Hubris Among CEOs and How to Prevent it, Journal of Business Ethics, 2012: 108: pp.265–283

QUESTIONS?