A Theory of Friendly Boards by ADAMS and FERREIRA (2007, JF)

1. Executive Compensation and Corporate StrategiesJi-Chai LinLouisiana State UniversityFor 2014 Workshop at UESTC

2. A Theory of Friendly Boardsby ADAMS and FERREIRA (2007, JF) • This paper analyzes the consequences of the board’s dual role • as advisor as well as monitor of management. • Given this dual role, • the CEO faces a trade-off in disclosing information to the board: • If he reveals his information, he receives better advice; • however, an informed board will also monitor him more intensively.

3. the monitoring role of the board • The board of directors must review and approve • fundamental operating and financial decisions, and • other corporate plans and strategies. • Because managers’ preferred projects are not always those that maximize shareholder value, • directors must be willing to withhold approval and insist on change. • This active participation in the firm’s decision making characterizes • the monitoring role of the board.

4. The advisory role of the board • The board takes a more hands-off approach in its advisory role. • The board draws upon the expertise of its members • to counsel management on the firm’s strategic direction. • They contribute their opinions as to general policy, and their judgement whenever a problem comes up. • However, since many board members have full-time jobs in other corporations, • they rely on the CEO to provide them with relevant firm-specific information. • The better the information the CEO provides, the better is the board’s advice.

5. moral hazard problems and monitoring • Moral hazard problems arise • because the CEO’s preferred projects differ from those of the shareholders. • When monitoring by the board is successful, • the board effectively controls project selection, and • the CEO, unable to implement his preferred projects, loses valuable control benefits.

6. a trade-off in disclosing information to the board • the CEO faces a trade-off in disclosing information to the board: • If he reveals his information, he receives better advice; • however, an informed board will also monitor him more intensively.

7. independent boards • Independent boards monitor management more intensively. • Thus, the CEO faces a trade-off in sharing information. • On the one hand, the board will give better advice if the CEO shares his information. • On the other hand, information revealed by the CEO helps the board determine the range of options available to the firm. • The more precise the board’s information about these options, • the greater the risk to the CEO that the board will interfere in decision making. • As a result, they show that • the CEO will not communicate firm-specific information to a board that is too independent.

8. management-friendly boards can be optimal! • To encourage the CEO to share information, • shareholders may optimally elect a less independent or friendlier board • that does not monitor the CEO too intensively. • In other words, in selecting their boards, • shareholders may choose to play off one role against the other.

9. a dual board system • When the two roles are separated, • the CEO does not face a trade-off in providing information. • Their model therefore shows that, under certain conditions, shareholders prefer • a dual board system, the separation of the board’s advisory and monitoring functions, • to a sole board system. • While the dual board structure allows for the cleanest separation of the board’s two roles, • it is possible to replicate this structure by separating the roles through the use of board committees, • like audit committee as fulfilling some of the functions of a supervisory board.

10. policy implications • Because boards have been criticized for being too friendly to managers, • the NYSE, and NASDAQ now require that • independent directors play a more important role in firm governance. • In the context of their model, policies that enhance board independence • may be detrimental for shareholders in a sole board system, • but not for shareholders in a dual board system. • Shareholders are always at least weakly better off • if the board has an advisory role.

11. Strategic flexibility and the optimality of pay for sector performanceby Gopalan, Milbourn, and Song (2010, RFS) • One of the basic tenets of compensation theory is that • optimal incentive-based pay should depend on variables under the manager's control • and not on those over which she has no control. • While standard contract theory suggests that • a CEO should be paid relative to a benchmark that removes the effects of sector performance, • there is evidence that CEO pay is strongly and positively related to such sector performance. • Many have coined this relationship as pay for firm performance due to luck. • This paper provides an alternative explanation …

12. Strategic flexibility • They model a CEO charged with selecting the firm's strategy, • which determines the firm's exposure to sector performance. • While there are clearly market forces at work that are beyond the executive's control, • the CEO typically has at least some discretion over the firm's exposure to such forces • through the choice of the firm's strategy. • To incentivize the CEO to choose optimally, • pay contracts will be positively and sometimes asymmetrically related to sector performance.

13. CEO’s job • To understand CEO pay, • we should first specify what CEOs actually do in that role. • The Board of Directors is not primarily concerned with • how hard the CEO is actually working, • but whether she has the vision to choose the right strategy for deploying the firm's assets. • In doing so, the CEO concerns herself with • the firm's strategic direction in lieu of its surrounding market environment: • Where is the sector going and how does the firm fit into it? • What type of exposure to the sector is optimal for the firm? • Thus, choosing the firm's strategy, • CEO affects the firm's exposure to sector movements.

14. CEOs actively influence firm strategy • CEOs have become more highly valued for their general management skills, rather than for their firm-specific knowledge. • This is akin to a world where CEO ability is linked explicitly to navigating the firm within the broad market.

15. optimal incentive contracts • The optimal contract rewards the CEO for firm performance • induced by sector movements so as to provide her incentives to • exert effort to forecast the sector movements and • choose the firm's optimal exposure to them. • Benchmarking the CEO's performance against her sector • is the same as not offering her pay for sector performance and • will make firm investment decisions insensitive to sector movements. • This practice is suboptimal if sector performance affects firm performance.

16. Main findings on the sensitivity of pay to sector performance • 1. Multi-segment firms, • especially those in which the sector performances of the different segments are less positively correlated, • will offer pay contracts that are more sensitive to sector performance as compared to single segment firms. • This is because such firms provide greater opportunity to the CEO to actively shift resources towards sectors that are likely to outperform. • 2. The sensitivity of pay to sector performance will be greater in any firm that • offers greater strategic flexibility to the CEO to alter firm exposure to sector movements and for more talented CEOs.

17. Asymmetric pay • the optimal contract • rewards a risk-averse CEO more when sector performance is good than • punishes her when sector performance is bad; • that is, the optimal contract is asymmetrically sensitive to good and bad sector performance.

18. Two proxies for strategic flexibility • 1. the industry market-to-book ratio. • Industries with high market-to-book ratios are likely to have greater investment and growth options and • thereby offer CEOs greater strategic flexibility in timing the exercise of those options. • 2. the level of R&D expenditures in an industry. • Firms in industries with higher levels of R&D expenditures are likely to provide their CEOs with greater strategic flexibility. • In these industries, the CEO has more latitude to scale up or down such expenditures and thereby change the firm's exposure to market conditions.

19. Pay and strategic flexibility • Pay for sector performance is in fact greater • for the subsample of firms in industries with high market-to-book ratios. • Similar results hold when they measure strategic flexibility using industry R&D expenditures.

20. evidence of strategic flexibility • firms with greater pay for sector performance to show some evidence of CEOs exploiting their strategic flexibility to a greater extent at the firm level. • CEO pay is more sensitive to sector performance in firms that have • positive industry-adjusted R&D expenditures the following year and • positive industry-adjusted asset-growth rates during the sample period. • the likelihood of a disciplinary CEO turnover is sensitive to sector performance • only in firms from industries with high market-to-book ratios and R&D expenditures.

21. The Role of Stock Liquidity in Executive Compensationby Jayaraman and Milbourn (2012, Accounting Review) • Explore the role of stock liquidity in influencing the composition of CEO annual pay and the sensitivity of managerial wealth to stock prices.

22. Main findings • 1. As stock liquidity goes up, • the proportion of equity-based compensation in total compensation increases • while the proportion of cash-based compensation declines. • 2. The CEO’s pay-for-performance sensitivity with respect to stock prices • is increasing in the liquidity of the stock. • The main findings are supported by additional tests • based on shocks to stock liquidity and • two-stage-least squares specifications that mitigate endogeneity concerns.

23. Implications • The evidence is consistent with optimal contracting theories. • It contributes to the ongoing debate about the increasing trend of both • equity-based over cash-based compensation and • the sensitivity of total CEO wealth to stock prices rather than earnings.

24. Stock market liquidity and firm valueby Fang, Noe, and Tice (JFE, 2009) • In theoretical analyses, liquid markets have been shown to • permit non-blockholders to intervene and become blockholders • (Maug (1998)), • facilitate the formation of a toehold stake • (Kyle and Vila (1991)), • promote more efficient management compensation • (Holmstrom and Tirole (1993)), and • stimulate trade by informed investors,

25. Stock liquidity and corporate investments • Thus, liquid markets improve investment decisions and make share prices more informative • (Subrahmanyam and Titman (2001) and Khanna and Sonti (2004)). • Therefore, a priori, a positive relation between liquidity and performance is quite plausible. • However, empirical researchers have not made this relation the center of systematic empirical investigation.

26. The goals of this paper • to fill this gap in the literature by examining whether and why liquidity affects firm performance. • Firm performance: • Captured by market-to-book

27. Decomposing M/B • Market-to-book • = (Vd + Ve)/(Assets) = [(Vd + Ve)/Op. Income] × [Op. Income /Assets] =[Ve/Op Income] × [(Ve + Vd)/Ve] × [Op. Income/Assets] = (Price to Op. Income) × (Firm Value to Market Value of Equity) ×(Operating Income to Assets)

28. Three components of M/B • Thus, the market-to-book ratio is separated into the following components: • price-to-operating earnings ratio (OIP); • leverage ratio; and • operating return on assets ratio.

29. Empirical results

30. Empirical results • More liquid stocks have • higher operating returns on their assets and • more equity in their capital structure. • In contrast, their price-to-operating earnings ratios (P/E) are similar to less liquid stocks.

31. Robustness checks • These results hold when they control for • industry and firm fixed effects, the level of shareholder rights, stock return momentum, idiosyncratic risk, analyst coverage, and • endogeneity using an instrumental variables procedure.

32. Exogenous shocks to stock liquidity • An exogenous shock to liquidity on firm performance: • Decimalization increased stock liquidity in general but • it increased more for actively traded stocks. • The change in liquidity surrounding decimalization is used as an instrument for liquidity: • stocks with a larger increase in liquidity following decimalization have a larger increase in firm performance.

33. Fig. 2. Value-weighted daily average effective spread, NYSE, 1993–2002.

34. How does liquidity improve firm performance? • How does liquidity improve firm performance? • Making price more informative to stakeholders • Permitting more effective contracting on stock price regarding compensation • Allowing non-blockholders to intervene and become blockholders

35. What types of firms benefit the most from stock liquidity? • In support, this study documents that the positive effect of liquidity on firm performance is • the greatest for liquid stocks • with high business uncertainty (high operating income volatility or high R&D intensity).

36. Conclusion • This paper investigates the relation between stock liquidity and firm performance. • firms with liquid stocks have better performance as measured by the firm market-to-book ratio. • This result is very robust. • To identify the causal effect of liquidity on firm performance, they study an exogenous shock to liquidity---the decimalization of stock trading---and document that • the increase in liquidity around decimalization improves firm performance. • The causes of liquidity’s beneficial effect are investigated: • Liquidity increases the information content of market prices and of performance sensitive managerial compensation.

37. Duration of Executive Compensationby Gopalan, Milbourn, Song, and Thakor (2013, JF forthcoming) • executive compensation is an important tool of corporate governance • in aligning the interests of shareholders and managers. • Jensen and Murphy (1990) argued famously that • what matters in CEO pay is not how much you pay, but how you pay. • To this end, an active debate has raged on about what should be • the optimal duration of executive compensation. • excessive compensation short-termism could lead to • self-interested and often myopic managerial behavior.

38. a number of important yet unanswered questions • questions: • How do firms determine the duration of their executive compensation contracts? • How is compensation duration related to various firm and industry characteristics? • How do observed compensation contracts relate to existing theories? • How does past stock performance influence compensation duration? • Does the duration of the compensation contract affect the executive's incentives to boost short-term performance? • Addressing these questions is hampered by an obvious gap in our knowledge • since we have no existing measure that helps to quantify the extent to which executive compensation is short-term or long-term.

39. a novel measure of pay duration • This measure is a close cousin of the duration measure developed for bonds. • The measure is: • The weighted average of the vesting periods of the different components of executive pay • (including salary, bonus, restricted stocks, and stock options), • with the weight for each component being the fraction of that component in the executive's total compensation package.

40. Hypothesis and Main findings • They hypothesize that • firms with more valuable long-term projects and less risky firms offer their executives longer-duration pay contracts. • To measure the duration of the firm's projects, • they use market-to-book ratio, the fraction of long-term assets and R&D intensity. • Finding: Executive pay duration is longer in firms with higher market-to-book ratio, for firms with more long-term assets and in more R&D-intensive firms. • Consistent with their hypothesis, they also find that • riskier firms offer shorter-duration pay contracts.

41. Main findings_2 • the vesting periods of both stock and option grants cluster around three to five years. • significant cross-sectional variation in the pay duration across industries. • e.g., executive pay duration is correlated with project and asset duration, • industries with longer-duration projects, such as Defense and Utilities, offer longer-duration pay to their executives. • firms in the Finance-Trading industry have above-median pay duration (they rank 11th among the 48 industries).

42. Main findings_3 • the average pay duration increased during the sample period, • especially for executives in the manufacturing and utilities industries. • The average pay duration for all executives (including those below the CEO) in our sample is around 1.22 years, • while CEO pay has a slightly longer duration at about 1.44 years. • Executives with longer-duration contracts receive higher total compensation, • but lower bonus, on average.

43. Main findings_4 • firms with better recent stock performance • offer longer-duration pay contracts to their executives. • This may be because • realized stock returns are positively correlated with inferences about executive ability, • so Boards find it optimal to lengthen vesting schedules to increase the cost of voluntary departure for executives with higher perceived ability.

44. Main findings_5 • Pay duration is shorter for executives with higher ownerships in their own firms. • But, longer in firms with a larger fraction of independent directors on the board.

45. Main findings_6 • Managers with shorter-duration pay contracts are expected • to have a stronger proclivity to boost short-term earnings, and • hence such firms should be associated with higher abnormal accruals. • Indeed, they find a strong negative association • between CEO pay duration and abnormal accruals: • i.e., firms that offer shorter-duration pay contracts to their CEOs have higher abnormal accruals in the current period. • The negative association • between CEO pay duration and the level of abnormal accruals • is stronger for small firms, young firms, and firms with less liquid stocks.