Monday, November 01, 2004

Trends in Corporate Governance--Hermalin

In a forthcoming Journal of Finance article, Hermalin does a great job of showing how the various trends we see in corporate governance may be linked.

Some of the trends that are investigated include more "diligent boards", more outsiders being hired as CEOs, shorter tenures as CEO, and of course more CEO pay.

In the author's own words:
If regulatory and other pressures are leading to, say, more diligent boards of directors, what else should we expect to see as consequences? Furthermore, how do the various trends in governance relate to each other? What trends may plausibly be causing other trends? What covariance in trends may simply be spurious? The purpose of this paper is to develop a theoretical framework from which to answer such questions. This framework allows one, for instance, to trace through the consequences of pushing for greater representation of outsiders on boards for matters such as who gets hired as Chief Executive Officer (CEO), how long he might be expected to serve, and how much he might expect to be paid.
Using modeling that may be above the level of an undergraduate class, Hermalin shows that many of these trends may be connected. For instance, consider the trends of more diligent boards, more outside hires, and shorter turnover as CEO. He shows that these are likely linked.

How? Suppose boards are more diligent (the reason could be regulation or as a result of past "Enrons" or merely because of sun spot activity--in other words the reason for this increased diligence is immaterial). What would be some fo the consequences of this increased board diligence?

Hermalin points out that boards play the biggest role in the hiring and firing of CEOs so the paper is focused on this.

If CEO hiring decisions are considered using option theory, outside applicants have an advantage. Why? More is unknown about the outsider than the insider applicant. Thus, there is a higher variance on the ability of the outsider. Coupled with the ability to remove the CEO for poor performance (capping the downside), this leads to an increased expected value of hiring the outsider as CEO. (Which is a really cool insight!)

So if the board is already monitoring the CEO (i.e. more dilegence by Boards), then this is a relatively cheap option to exercise. So with increased monitoring, we should expect to see more outside CEO hires and of course more CEOs being fired (i.e. shorter tenures).

As evidence of this, the author points out that we should see more independent boards hiring more outsiders:
"Given the perceived wisdom that outside directors are more independent or otherwise more inclined to monitor, this suggests that the tendency to hire external candidates increases with the proportion of outside directors on the board. This prediction is consistent with the empirical findings of Borokhovich et al. (1996) and Dahya and McConnell (2001), who find evidence in support of this hypothesis using U.S. and U.K. data, respectively."

Additionally, since CEOs do not like to be monitored, closer monitoring by boards may partially explain the higher CEO pay levels we are seeing.

Now of course, there are alternative explanations for many of these trends and even some contradictory evidence (for example, more institutional ownership and stronger boards being associated with LOWER CEO pay). In section VI of the paper the author comments on these other explanations and concludes that they are all missing some important part of the story. Which I find not totally convincing, but it is still a great paper!

Overall, one of those papers that opens you up to a new way of thinking about things. And that may be the best compliment an academic paper can receive!

The paper is currently available on the Journal of Finance site, but will be removed once it goes to print.

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