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«Three essays on corporate boards R. Øystein Strøm A dissertation submitted to BI Norwegian School of Management for the degree of Dr.Oecon SERIES ...»

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How do the results for governance mechanisms in co-determined firms compare to those in shareholder determined? It turns out that the board index is positive, and leverage negative, as before. However, leverage is no longer significant. The fewer and weaker results for shareholder determined firms indicate that governance mechanisms are set closer to equilibrium than in co-determined firms.

The reverse causation hypothesis finds confirmation, too. However, these are weak, and contrary to the Hermalin and Weisbach (1998) suggestion. Thus, governance mechanisms are only weakly endogenously determined by former firm performance. Their overall effects upon firm performance are very low. Thus, I find evidence of reverse causation, but the effects are almost negligible.

Robustness tests generally confirm the results. Replacing Tobin’s Q as a measure of firm performance with the book return on assets (ROA) and the stock return does not materially upset former findings. I also try the dividend payout rate instead of leverage, but find the variable to have little explanatory power. Dropping the lagged firm performance does not upset coefficient values in other variables much. In general, the robustness tests are very satisfactory.

Finally, I test the Fauver and Fuerst (2006) finding that co-determination plays a positive role in information intensive industries. These are industries requiring high knowledge content, but also firms running complex logistic operations, such as retailing. Estimations are carried out in subsamples of information industries and other industries. It turns out that

1.4. BOARD CONTROL 11 the same qualitative pattern of impacts from employee directors turns up in both estimations, although the impact of employee directors is somewhat weaker in the information industries. A Chow test of different coefcient values in the two sub-samples can not be confirmed.

In conclusion, the idea that employee directors could add value to the company does not find support in the data. Co-determination, mandated in law, has costs for the firms, both in shareholder attempts to neutralize the effects, and probably also in terms of a slower, consensus-oriented decision process.

1.4 Board control, turnover and turbulence

The co-determination paper deals with the relationship between owners and employees, and this paper looks at the relationship between owners and the CEO. Agency problems stand at the center of this relationship (Berle Jr. and Means, 1932 and Jensen and Meckling, 1976), and the protection of minority shareholders has come to be seen as a way to reduce the extent of agency costs (Shleifer and Vishny, 1997). In this paper, I argue that the timing of CEO departure relative to board enlargements and director substitutions can shed light on the relationship, since different board control types give diverging predictions on the relative timing of departures. The present essay is related to the Goyal and Park (2002) study of CEO turnover when the CEO holds the joint office of chairman, and Falaye (2007) who investigates the CEO turnover for staggered boards.

CEO-chairman duality and staggered boards may be seen as CEO protection from shareholders’ discipline. The Norwegian company law does not allow such protection (Aarbakke et al., 1999). Since the protection of minority shareholders is high, CEO turnover and board changes may be studied unhampered by CEO or director protection.

By itself, CEO turnover is important, since this is one of the board’s primary functions (Monks and Minow, 2001, p. 200). Board changes are likewise important. The Berle Jr. and Means (1932) claim is that shareholders have lost control over the company, since they are dispersed, and because the CEO controls the appointment of new directors.

I differentiate between three board control types. The first is the Berle Jr. and Means (1932) CEO control, where the CEO in effect elects his own directors. The Hermalin and Weisbach (1998) model of the “endogenously determined” board shows the CEO in control. Upon turning in good firm performance, the CEO is rewarded a reduction in monitoring intensity,

CHAPTER 1. OVERVIEW

which they interpret to be a less independent board. This is achieved either by independent directors leaving, to be replaced by inside directors, or by an inside director board enlargement. The implication is that directors leave during the CEO tenure.

One could expect that the Hermalin and Weisbach (1998) model predicts a board independence increase following weak firm performance.

Yet the authors disregard shareholders due to the US institutional fact that shareholders are dispersed. But this points to a rival explanation involving the concentration of ownership. The Shleifer and Vishny (1986) and Bolton and von Thadden (1998) proposition says that the higher outside ownership concentration, the higher is monitoring effort. From this it follows that director turnover is higher as well. Given CEO control, outside ownership concentration should have no association with director turnover.

Under the second control type, the board fulfils its primary function of hiring and firing the CEO. I call this “shareholder control”. In this case, the turnovers of CEO and directors are unrelated, but board changes should be related to outside ownership concentration and CEO turnover should be unrelated. The third control type is “joint control”, when the board and the CEO together form a team, and are jointly responsible for firm performance. Since they are jointly responsible, a prediction is that the CEO and director turnovers will be simultaneous. Thus, the fact that the three control types imply different patterns of timing in CEO turnover and board changes can be used to examine whether the typical director election is under shareholder or CEO control. Also, the three types of board control give different predictions regarding outside ownership concentration.





No earlier authors have utilised the relative turnover timing of CEOs and directors to investigate the potential for agency problems. In recent papers, Farrell and Whidbee (2000); Yermack (2004), and Fich and Shivdasani (2006) all show that outside directors are more likely to leave when a new CEO takes office. But none of the authors make the timing of CEO and director departures the central issue of study.

Besides simultaneity and outside ownership I include variables that often appear in turnover studies, such as CEO and director ownership, board independence, and firm performance. I also include the board network. A board with better network connections may be less likely to experience turnover, since such a board turns out create value (Ferris et al., 2003 and Bøhren and Strøm, 2007). However, Fich and Shivdasani (2006) point out that a board with many outside directorships is less likely to discharge the CEO. Besides these, three variables that may be seen as proxies

1.4. BOARD CONTROL 13 for either CEO entrenchment or information are in the independent variable set. These are exported CEO, imported CEO, and CEO director, see the AID essay in section 1.2.

Board changes comprise director turnover and board enlargements. I join these in a single measure, called board turbulence. I am unaware if such a measure is already in use. Moreover, CEO turnover is defined in three different ways. The first is all CEO turnovers, the second the CEO departures that coincide with a chairman departure, and the third is the forced departures from Bøhren et al. (2002). The common practice is to use the forced departures, but Yermack (2004) is an example of a study employing all CEO turnovers.

I include all CEO turnovers for the following two reasons. First, the timing of CEO turnover and board turbulence may reveal board control type, for whatever reason the departing CEO left the company. Thus, for this reason alone, all CEO changes belong to the data set. Second, public information on dismissals is likely to emerge only in a minority of cases, probably where the conflict is the most acute, since both the firm and the departing CEO want to defend their reputational capital. Using only this sub-sample of turnovers is, consequently, likely to result in a seriously biased sample.

The panel data structure of Norwegian boards from 1989 to 2002 offers the opportunity to study departures around the time of CEO turnover. I run three types of regressions. In the first, CEO turnover is the dependent variable and a lagged and simultaneous board turbulence are dependent.

The second group of regressions comprises the chairman as the dependent variable, and in the third, board turbulence is taken as the dependent, while the lagged and simultaneous CEO turnover are independent. The regressions for the chairman is done due to the position’s importance. In addition to the CEO, chairman, and board turbulence variables, the abovementioned variables enter the regressions.

When the CEO turnover is the dependent variable, I use the so-called probit regression technique. Probit regressions are necessary because CEO turnover is a binary variable. Since the method does not remove firm heterogeneity, I have added 14 year and 19 industry dummies in order to control for as much of the firm’s fixed effects as possible. Furthermore, with panel data it is not possible to standardise the variables, although the slope coefficients may be observed at the average of the distribution.

These are called average partial effects (APE). Furthermore, the same probit methodology is used in regressions with the chairman departure as

CHAPTER 1. OVERVIEW

dependent variable.

When board turbulence is the dependent variable, I use GMM estimation in the same manner as in section 1.2, with the exception that lagged explanatory variables enter the regressions.

I focus upon the simultaneity of CEO departure and board turbulence in the three regression groups as well as the role of outside ownership.

When the CEO turnover is the dependent variable, I find that the simultaneous and lagged board turbulence are both significant and positive, but the simultaneous is higher than the lagged, that is, the simultaneous APE is higher than the lagged. Thus, the CEO board control type receives little support. Furthermore, the outside ownership concentration is not significant, as is expected under shareholder and joint control. These results hold across various definitions of CEO turnover, and for firm performance being either stock return or return on assets.

The same conclusions emerge when using the chairman as the dependent variable. Now, the CEO turnover variable is simultaneous and lagged. The chairman is removed in the board turbulence measure, and the regression using joint CEO and chairman turnover is removed from the estimations.

The third regression group comprises the board turbulence as the dependent variable. Here, the simultaneous and lagged CEO turnover are both significant, but the lagged is more important. This should indicate CEO control. However, now the outside ownership concentration is significant and positive, as expected when shareholder control is the case.

My main conclusion is that the control type between CEO and directors is one of joint control, that is, the CEO and directors together constitute a team. This supports the friendly board hypothesis of Adams and Ferreira (2007).

Thus, the data do not support the Hermalin and Weisbach (1998) hypothesis that board composition is endogenously determined. It seems that CEO control can only be realised if some protection is given, for instance in the form of CEO-chairman duality or a staggered board, as Goyal and Park (2002) and Falaye (2007) report. The results in this paper show that when such protection is not in place, shareholders are important in choosing directors. By implication, for the CEO to gain control over the board, regulations must favour CEO protection.

1.5. LOOKING BACK 15

1.5 Looking back

Looking back at the essays, three main conclusions seem to emerge. The first is that the board matters for firm performance. Board characteristics play a role for the success of companies, and firms are advised to keep boards small, well informed, and aligned with shareholder interests. The second main conclusion is that endogeneity exists, but compared to the effects of board characteristics, it is of minor importance. The third conclusion is that government regulations matter. This is obvious for the negative effects of co-determination, but also for the strong protection of minority shareholders. This protection allows shareholder discipline to be exercised in the relation to the CEO.

Bibliography Aarbakke, M., J. Skåre, G. Knudsen, T. Ofstad, and A. Aarbakke (1999).

Aksjeloven og Allmennaksjeloven. Oslo: Tano Aschehoug.

Adams, R. B. and D. Ferreira (2007, Feb). A theory of friendly boards.

Journal of Finance 62(1), 217–250.

Agrawal, A. and C. R. Knoeber (1996, Sep). Firm performance and mechanisms to control agency problems between managers and shareholders.

Journal of Financial and Quantitative Analysis 31(3), 377–397.

Baker, G. P., M. C. Jensen, and K. J. Murphy (1988, Jul). Compensation and incentives: Practices vs. theory. Journal of Finance 43(3), 593–616.

Barca, F. and M. Becht (2001). The Control of Corporate Europe. Oxford, UK:

Oxford University Press.

Barclay, M. J., C. W. Smith, and R. L. Watts (1995). The determinants of corporate leverage and dividend policies. Journal of Applied Corporate Finance 7(4), 4–19.

Becht, M., P. Bolton, and A. Röell (2003). Corporate governance and control. In G. Constantinides, M. Harris, and R. Stulz (Eds.), Handbook of

the Economics of Finance, Volume 1A, Chapter 1, pp. 1–109. Amsterdam:

North-Holland.

–  –  –

Bertrand, M. and S. Mullainathan (2001, Oct). Are CEOs rewarded for luck? The ones without principals are. Quarterly Journal of Economics 116(3), 901–932.

Bhagat, S. and B. Black (1999, May). The uncertain relationship between board composition and firm performance. The Business Lawyer 54, 921– 963.

Blair, M. M. and L. A. Stout (1999). A team production theory of corporate law. Virginia Law Review 85(2), 247–328.

Bøhren, Ø., S. Sharma, and T. Vegarud (2002). Eierstyring i store norske selskaper: oppsigelse av toppleder. In Corporate Governance i et norsk perspektiv, pp. 124–137.



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