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FIN 7340 Corporate Theory II. Dr. Nina Baranchuk. Boards of Directors as an Endogenously Determined Institution. Benjamin E. Hermalin Michael S. Weisbach Presented by: Michael Keefe January 18, 2006.

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Boards of directors as an endogenously determined institution l.jpg

FIN 7340 Corporate Theory II

Dr. Nina Baranchuk

Boards of Directors as an Endogenously Determined Institution

Benjamin E. Hermalin

Michael S. Weisbach

Presented by: Michael Keefe

January 18, 2006


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“The directors of [joint stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance [as owners]....Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company”

Adam Smith -1776


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Key Questions the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance [as owners]....Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company”

  • How do board characteristics or size affect profitability?

  • How do board characteristics affect observable actions of the board?

  • What factors affect the makeup of boards and how do they evolve over time?


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Introduction – Survey Paper the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance [as owners]....Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company”

  • Definition – An economic institution that, in theory, helps to solve agency problems inherent in managing an organization.

  • Formal theories limited

  • Major Conflict – Between CEO and Board

  • Significant empirical work, but little motivated by theory


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Empirical Regularities the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance [as owners]....Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company”

  • Composition (insider/outsider ratio) does not imply profitability

  • Number of directors is inversely related to performance

  • Board actions are related to board decisions( insider/outsider ration is related toPoison Pills, Acquisitions, Compensation)

  • Boards evolve relative to bargaining position of CEO


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Theory the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance [as owners]....Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company”


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Why are there boards? the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance [as owners]....Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company”

  • Regulation Driven –

    • Boards pre-date regulations

    • Larger than required by law

  • Hypothesis

    • Market solution to an agency problem

    • Endogenously determined institution

  • Provides contracts and incentives to management

  • Shleifer and Vishny (1986) – Free-Rider problem alleviated by large outside shareholder. Power of shareholder works through board.

  • Meissner (2000) – Side payments greater than gains for bad loans.


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What do they do? the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance [as owners]....Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company”

  • Outside Director as a Monitor

    • Fama (1980), Fama and Jensen(1983) – build reputation as expert monitor

    • Kaplan and Reishus (1990) – build reputation as doesn’t make trouble

  • Hermalin and Weisbach (1998) Board Specific Model

    • Board decides to keep or fire CEO

    • CEO ability linked to performance

    • CEO prefers less independent board

    • CEO bargaining power related to performance


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Hermalin and Weisbach Predictions the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance [as owners]....Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company”

1* Poor performance=>increase probability of replacement

2* Board independence => higher CEO turnover

3* Poor performance => more independent directors

4* CEO tenure=>less board independence

5* Accounting measures better predictor of tenure than stock performance

6 Long Term persistence in corporate governance

7 CEO fired

  • Private information => negative return

  • Public Information => positive return

    8 CEO Salary

  • Low Levels of Performance => limited affect to salary

  • High Levels of Performance => affects salary

    * Strong empirical support


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Empirical Results the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance [as owners]....Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company”


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Empirical Issues the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance [as owners]....Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company”

  • System

    • Actionst+s= φCharacteristics + ε

    • Profitst+s = βActions + η

    • Characterisitcst+s = μProfits + ξ

  • Equilibrium or Out-of-Equilibrium?

  • Methods

    • Typically not jointly estimated

    • Endogeneity handled with lags


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Tobin's q the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance [as owners]....Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company”

  • Tobin's q = market value / asset value

  • If the market value = asset value => Tobin's q= 1.0.

  • If Tobin's q > 1.0, then market value > than the value of the company's recorded assets.

  • Tobin's q reflects a number of variables, and in particular:

    • The recorded assets of the company.

    • Market sentiment, reflecting, for example, analysts' views of the prospects for the company, or speculation such as bid rumors.

    • The intellectual capital of the company.

  • Source: Wikepedia


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    Outside Directors and Performance the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance [as owners]....Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company”

    • Method: Contemporaneous Correlations with accounting measures and Tobin q

    • Results: No Evidence supporting outside directors and performance

    • Issue: Endogeneity – Poor performance leads to independent boards (Hermalin and Weisbach 1998)

    • Method1: Lagged Performance as instrument for current performance

    • Results1: No Evidence supporting outside directors and performance

    • Method2: Rosenstein and Wyatt (1990) use event study for outside directors added to board

    • Result2: Some evidence - .2% increase in return

    • Benefit of Method: Controls for all firm specific effects


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    Board Size and Performance the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance [as owners]....Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company”

    • Jensen (1993) and Lipton and Lorsch (1992) suggest increase board size leads to agency problems

    • Yermack (1996) – Negative Relation between board size and Tobin’s q

    • Gertner and Kaplan (1996)

      Study: Board sizes of reverse leverage buyouts Method:board size smaller than comparable firm

    • Equilibrium or out of equilibrium – Why hasn’t economic darwinism eliminated the unfit organizational form?


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    Board Size and Tasks (actions as a function of characteristics)

    • CEO Turnover

      • Findings: Robust relationship between turnover and performance

      • Empirical issue – voluntary or non-voluntary

    • Weisbach (1988)-

      • Approach: interacts board composition with firm performance

      • Finding: CEO turnover more sensitive to firm performance with outside directors.

      • Robust to performance as measured by accounting or market measures

      • CEO turnover with insider dominated boards not performance sensitive

    • Yermack (1996) and Wu (2000) – Interact board size with performance and find smaller boards are more effective overseers of CEOs.

    • Perry (2000) – Incentive pay also significant


    Evidence from takeover market l.jpg
    Evidence from Takeover Market characteristics)

    • Shivdasani (1993) –

      • Question: probability of takeover in a hostile bid?

      • Finding: Additional directorships => lower probability

      • Why?

    • Cotter et al. (1997)

      • Question: Relationship between return from hostile takeover and outside directors

      • Result: Majority of outside directors=>20% increase in return.

    • Harford (2000) – Documents pecunary interests of directors to resist a takeover.

    • Byrd and Hickman (1992)

      • Question: Relationship between return when acquiring

      • Results:

        • -1.33% abnormal return for entire sample

        • -.07% abnormal return if 50% of directors outside

        • -1.86% abnormal return if minority of directors outside


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    Poison Pills characteristics)

    • Effect can be argued both ways:

      • Protect Management

      • Increase bargaining position

    • Brickley et al. (1994)

      • Method: Split sample, analyzed market reaction

      • Results: Poison Pill Announcements=>

        • Decrease in price if majority inside directors

        • Increase in price if majority of outside directors


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    Executive Compensation characteristics)

    • Core et al. (1999)

      • Results: Weaker goverance => Higher CEO pay

      • Measures:

        • Outsiders appointed by CEO

        • Directors over 69

        • Board Size

        • Busy Directors (additional directorships)

        • Interlocking Directors

    • Yermack (1996) – pay for performance increases with small boards


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    Board Dynamics characteristics)

    • Changes in a firm’s characteristics =>changes in board composition

    • Hermalin and Weisbach (1988)

      • Poor Performance => more outside directors

      • CEO succession imminent => more inside directors

      • Firm leaves a product market => inside directors depart


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    CEO Power Struggle with Board characteristics)

    • Fundamentally Unobservable

    • Approaches

      • Hallock (1997 1999) - Interlocking directorships

      • Shivdasani and Yermack (1999) – board selection process (e.g. seperate nominating commitee)

      • Baker and Gompers (2000) – CEO voting stake => board selection in IPO


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    Industry Studies characteristics)

    • Hospitals – non-profits and for-profit hospitals

    • Brickley and Van Horn (2000) – can’t reject that both types maximize the same objective function

    • Eldenberg et al. (2000) – find sensitivity to CEO turnover related to hospital performance, high admin costs, and high levels of uncompensated care vary by hospital type.


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    Future Research Directions characteristics)

    • Model inner workings of boards

    • Test implications of models

    • Study different type of boards – nonprofits, smaller firms, etc.


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