Mandated divorce: company boards, incentives and performance

Abstract

This article highlights some of the findings of a very extensive paper involving both a new economic theory of governance and a range of major empirical tests. In this extensive paper, I rectify the market governance model of B Holmstrom and J Tirole, “Market liquidity and performance monitoring” (1993) 101 Journal of Political Economy 678–709, reverse many of their theoretical findings without altering their assumptions, and develop and test a number of hypotheses concerning company board structure and incentives in the presence of informed trading of company shares in the stock market. Both Bengt Holmstrom (2016) and Jean Tirole (2014) are recent Nobel Laureates. In my theory, the use of market-based incentives for the CEO and board members diminishes with firm size as larger firms benefit more from this informed trading which I equate with “market monitoring” of board decisions. Most studies of the impact of changes in company board composition prior to this suffer from problems due to the “endogeneity” of board compositional changes with such changes potentially due to specific problems facing individual companies. This makes cause and effect difficult to disentangle. Here “exogeneity” stems from the forced departure of “non-independent” directors with substantial shareholdings from boards due to regulatory-induced pressure. These departures are due to the peculiar recommendations of the Australian Securities Exchange (ASX) Corporate Governance Council (CGC) who deem substantial shareholders on company boards to be “non-independent”. Interestingly, the UK regulator adopts the same peculiar stance. Various market and accounting measures of performance, investment decision-making with respect to acquisitions, and negotiation and monitoring of CEO and non-executive director pay substantially worsen in the presence of this external market monitoring by informed institutional traders. I conclude that informed traders utilize information about the actions of board members that reinforce the market-based incentives of CEOs, other executives, and outside directors with substantial shareholdings.

Notes

1 DR Gallagher, PA Gardner and PL Swan, “Governance through Trading: Institutional Swing Trades and Subsequent Firm Performance” (2013) 48 Journal of Financial and Quantitative Analysis 427.

2 B Holmstrom and J Tirole, “Market liquidity and performance monitoring” (1993) 101 Journal of Political Economy 678–709.

3 “The Complementary Roles of Board Incentives and Market Monitoring: Theory and Evidence”, FIRN Research Paper No 2766185 (24 August 2016), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2766185 accessed on 20 October 2016.

4 ASX Corporate Governance Council, “Corporate Governance Principles and Recommendations” (3rd edn, 2014), 17, http://www.asx.com.au/documents/asx-compliance/cgc-principles-and-recommendations-3rd-edn.pdf accessed on 20 October 2016.

5 ASX Corporate Governance Council, “Principles of Good Corporate Governance and Best Practice Recommendations” (March 2003), http://www.shareholder.com/visitors/dynamicdoc/document.cfm?documentid=364 accessed on 20 October 2016. The ASX CGC recommendation to exclude significant shareholder directors as being “non-independent” was adopted from the Investment and Financial Services Association (IFSA) Blue Book recommendations put out by (of all people) the private superannuation and life assurance funds.

6 This research is discussed in an earlier article I authored on independent directors, published in 2014. See P Swan, “The ASX Governance Council and ‘Independent’ Boards” (2014) 8(3) Law and Financial Markets Review 196.

7 “To describe a director as ‘independent’ carries with it a particular connotation that the director is not allied with the interests of management, a substantial security holder or other relevant stakeholder and can and will bring an independent judgement to bear on issues before the board”. ASX CGC, “Corporate Governance Principles and Recommendations” (3rd edn, 2014), supra n 3, 16.

8 Report of the Royal Commission into HIH Insurance. Released 16 April 2003. Commonwealth of Australia.

9 Warren E. Buffett, Chairman's Letter, Berkshire Hathaway (17 February 2004).

10 Berkshire Hathaway Chairman's (Warren Buffett's) Letter to Shareholders, 2003 Annual Report, p. 9. http://www.berkshirehathaway.com/letters/2003ltr.pdf accessed on 20 October 2016.

11 Corporate Governance in the Nordic Countries, “Active Governance Role of Major Shareholders”, http://vi.is/files/Nordic%20CG%20-%20web_1472238902.pdf.

12 The Swedish Corporate Governance Board, http://www.corporategovernanceboard.se/ accessed on 20 October 2016.

13 RC Anderson and DM Reeb, “Founding-Family Ownership, Corporate Diversification, and Firm Leverage” (2003) 46 Journal of Law and Economics 653–684.

14 Presumably, the purpose of the legislation is to dilute the role of employers and especially unions on the boards of “Industry” funds even though they appear to perform better than “Retail” funds. A more justifiable reform would require all directors to place their own “nest eggs” in the funds they manage. See “Exposure Draft: Superannuation Legislation Amendment (Governance) Bill 2015”, http://www.treasury.gov.au/~/media/Treasury/Consultations%20and%20Reviews/Consultations/2015/Reforms%20to%20Superannuation%20Governance/Key%20Documents/PDF/150625-Draft-Legislation-Super-Legislation-Amendment-Bill-2015.ashx accessed on 20 October 2016.

15 Fit for the Future: A Capability Review of the Australian Securities and Investments Commission, A Report to Government (December 2015), 6, http://www.treasury.gov.au/~/media/Treasury/Publications%20and%20Media/Publications/2016/Fit%20for%20the%20future/Downloads/PDF/ASIC-Capability-Review-Final-Report.ashx.

Additional information

Notes on contributors

Peter L Swan

Peter Swan AO FASSA is Professor of Finance at the School of Banking and Finance, UNSW Australia Business School. This article is based on his November 2015 research paper “Board ‘Independence’ and the Complementary Roles of Board Incentives and Market Monitoring: Theory and Evidence” available at SSRN: 2766185 and his article that appeared in the Centre for Independent Studies Policy (Winter 2016). An earlier article on independent directors was published as “The ASX Governance Council and ‘Independent’ Boards” (2014) 8(3) Law and Financial Markets Review 196. Email: [email protected]