Technology, Residual Claimants, and Corporate Control

Transcription

1 Technology, Residual Claimants, and Corporate Control BARRY D. BAYSINGER Texas AOM University ASGHAR ZARDKOOHI Texas AirM University 1. INTRODUCTION Corporate law requires that incorporated firms be managed under the direction of a board of directors who are legally accountable to the firm's shareholders (Henn; Eisenberg). The latter delegate to the board the formal authority to hire, fire, and compensate thefirm'sprofessional managers. Economists have begun to study how governance structures like the board of directors limit managerial discretion (agency) in large corporations, economize on the transaction costs associated with this organizational form, and influence firm performance (Baysinger and Butler, 1985a; Fama and Jensen, 1983a, 1983b; Williamson, 1984). Along the same lines, organization theorists have examined the board's ability to set the premises of managerial decision making through the exercise of its formal authority and, hence, to control the goal setting and strategy formulation processes (Mizruchi). Preliminary empirical tests tend to support the notion that the board of directors contributes to the effective governance of large business corporations (Baysinger and Butler, 1985a). We would like to thank one of the coeditors of this journal, an anonymous referee, Henry Butler, and Mark Crain for helpful comments on an earlier draft of this paper. The usual caveat applies. Journal of Law, Economics, and Organization vol. 2, no. 2 Fall 1986 O 1986 by Yale University. All rights reserved. ISSN

2 340 / JOURNAL OF LAW, ECONOMICS, AND ORGANIZATION 11:2, 1986 This governance device is, however, but one of several institutional arrangements that serve to harmonize intracorporate conflicts of interests. Theorists have also identified important control capabilities in corporate law (Baysinger and Butler, 1985b), liberal dividend policies (Easterbrook), the market for corporate control (Manne; Easterbrook and Fischel), the managerial labor market (Alchian; Faith, Higgins and Tollison; Fama), performancecontingent reward systems (Jensen and Meckling), and administrative innovations such as the decomposition of strategic and operational decision making in multidivisional firms (Chandler; Williamson, 1970). The possibility of marginal substitutions among these alternative governance structures seems likely. For example, Faith, Higgins, and Tollison argue that in equilibrium, "the margins of several control devices are extended simultaneously to maximize the value of the firm, net of the cost of control" (660). This marginalist approach also implies that the intensity of efforts to control agency costs through formal governance structures would vary across organizations as an inverse function of the severity of agency problems faced by their shareholders (Baysinger and Butler, 1985a; Williamson, 1984). As Williamson (1983) has hypothesized, the governance responsibilities of directors should be reduced in multidivisional (M-form) firms because the decomposition of strategic and operating decisions in those organizations reduces the potential for conflicts of interest. This conclusion is likely to generalize to other control margins in the corporation as well. The purpose of this paper is to offer an initial empirical evaluation of this marginalist approach to the study of corporate governance. We postulate that while managerial discretion (agency) is everywhere a problem, the severity of the problem is not uniform across organizations or industries. This is due mainly to the emergence of specialized governance structures that safeguard equity investments from managerial opportunism. Of specific interest here is the effect of public utility regulation on the governance role played by the board of directors. According to the marginalist perspective on corporate governance outlined above, the composition of public utility boards should differ systematically from the composition of the boards of general industrial firms as shareholdermanager transactions in the former are regulated by public commissions. As Demsetz noted, upon finding that the managers of public utilities on average owned a smaller percentage of their firm's stock than their industrial counterparts, "If we suppose that regulation reduces the productivity of linking management interests to owner interests, the smaller fraction of shares owned by the managements of utilities makes sense" (388-89). This insight is combined with those of Faith et al. and Williamson (1983) as the basis for predicting systematic differences in the composition of the boards of utility and general industrial corporations.

3 TECHNOLOGY, RESIDUAL CLAIMANTS, & CORPORATE CONTROL / SPECIALIZED GOVERNANCE IN REGULATED UTILITY FIRMS The potential for managerial discretion (agency) arises in all economic organizations where the functions of decision management and residual risk bearing are specialized and performed by different parties (Alchian and Demsetz; Fama and Jensen, 1983a, 1983b; Jensen and Meckling; Williamson, 1981, 1984). Because they are typically large and organized as private corporations, public (that is, regulated) utility firms are not immune from agency problems. Thus it is no surprise that utilities, like general industrial corporations, are subject to corporate laws and securities regulations and have legally mandated boards of directors to harmonize conflicts that may arise among professional managers and residual claimants. What sets utilityfirmsapart is the additional layer of governance, in the form of the activities of public utility commissions, that exists to safeguard shareholder interests. From the perspective 6f transaction cost economics, the purpose of any corporate governance structure is to moderate hazards to invested capital and thereby facilitate shareholder trust and induce adequate levels of investment (Baysinger and Butler, 1985b). By providing safeguards to current and prospective shareholders (Williamson, 1984), governance structures such as the board of directors can thus "produce" efficiency in the acquisition of capital. Of course, where the operation of alternative governance structures reduces shareholders' exposure to the hazards of managerial discretion the productivity of the board is diminished. Since, crudely speaking, one of the main functions of public utility commissions is to regulate returns on invested capital, utility shareholders face fewer risks to their capital, ceteris paribus, than do the owners of general industrial firms. As Wilcox and Shepherd note, "The regulators themselves set much of theriskfactor precisely while they are setting in the ceiling (on return to equity). They do not find the profit-risk conditions: they make them" (356). Arguably, the marginal productivity of the board as a monitoring entity is less in utilities, ceteris paribus. Moreover, regulated public utilities, being generally more capital intensive than unregulated industrial firms, will have greater occasion to enter the organized financial markets to obtain capital. To the extent that utilities are active in the capital markets and emphasize the regular payment of dividends, they become exposed to increased scrutiny by institutional investors, financial analysts, lending institutions, and so forth. Consequently, individual utility shareholders mayfindthemselves more thoroughly protected by an umbrella of professionals who find it in their interest to monitor managerial conduct (Easterbrook). Once again, the direct oversight services provided by the board of directors should be less important in regulated utilities than in unregulated firms as a result. In sum, the attenuation of property rights experienced by utility shareholders as the result of rate of return regulation is a two-edged sword. Such

4 342 / JOURNAL OF LAW, ECONOMICS, AND ORGANIZATION 11:2, 1986 owners may have less direct control over the allocation of resources but, as Faith et al. note, "attenuating property right may have the effect of reducing the demand and supply of internal and external mechanisms for controlling managerial rent seeking" (665-66). If the welfare of shareholders in public utility corporations is substantially controlled by regulatory commissions, then the needs for and benefits accruing to shareholders from other governance structures are reduced. Two general hypotheses are thus suggested: 1. In regulated utilities shareholders are less reliant on directors to safeguard their investments, and this should be reflected in differences in the composition of utility boards when compared to the boards of unregulated firms. 2. The opportunity cost of employing directors to serve various nongovernance functions should be reduced in utility firms, and this also should be reflected in differences in the composition of boards of regulated and unregulated firms. 3. IMPLICATIONS FOR COMPARATIVE ANALYSIS This section presents the results of simple comparative tests to determine whether there is an alignment between the data and the predictions that flow from the comparative framework outlined above. The first step is to identify conceptually distinct components of corporate boards that might be expected to differ across regulated and unregulated firms. We envisage the board of directors of regulated and unregulated firms as a multipurpose body. At a minimum, the board can be used (1) as an instrument for protecting equity investments, (2) as an internal resource allocation choice, and (3) as a public relations instrument. All these tasks are "value maximizing," broadly conceived, but their relative importance, and, therefore, use can vary between regulated utilities and unregulated firms. Specifically, public utilities have the benefit of regulatory safeguards, which reduces equity exposure to opportunistic behavior on the part of manager-agents. This implies that the governance body of regulated utilities as compared to unregulated firms should have a smaller proportion of decision control directors, ceteris paribus. Decision control directors are board members who are brought in from external sources to ratify the decision initiatives of management and monitor the implementation of those initiatives. In regulated utilities these functions are to a large extent monitored by the regulatory body. Capital investment and employment decisions in unregulated firms generally depend on relative market prices. Such decisions in regulated firms, however, are affected by constraints imposed by regulators. For example, the rate of return in public utilities is controlled by regulation, thus affecting investment and consequently other input decisions. This implies that the board of directors of regulated utilities as compared to unregulated firms

5 TECHNOLOGY, RESIDUAL CLAIMANTS, & CORPORATE CONTROL / 343 should have a smaller proportion of decision managers and decision supporters, ceteris paribus. Decision managers have specific internal information about various functions and input needs; decision supporters, among other things, provide external information regarding input markets. Given that the board of directors offirmsis primarily composed of decision controllers, decision managers, decision supporters, and public relations members, the board of regulated utilities should, compared to unregulated firms, have a greater proportion of public relations members because these firms have relatively a smaller proportion of thefirst three board components. The comparative empirical analysis reported below was designed to determine if these predicted differences between regulated utilities and unregulated industrial firms exist METHODOLOGY Empirical analysis focused on the boards of firms listed on the New York Stock Exchange (NYSE) in Corporations listed on the NYSE are generally large complex organizations for which agency problems are a distinct possibility. All regulated utility firms listed on the exchange as of December 31, 1983, for which data were available were included in the study (N = 132). A sample of nonutility firms was chosen to represent the universe of large nonregulated firms. This sample was comprised of all large corporations falling into the category "General Manufacturing" (as defined by the annual Business Week survey) listed on the exchange as of December 31, 1983, for which data were available (N = 120). Board composition data. There are many ways to classify groups of differentiated elements such as boards of directors. For present purposes, directors on any given board may act as (1) decision managers, (2) decision controllers, (3) decision supporters, or (4) legitimizers or stakeholder representatives. These categories are designed to capture differences in the quality and composition of the board as suggested by the efficiency theory of the board. Decision managers are directors who also occupy active management positions in the sample firm. These individuals bring to board deliberations firm-specific information relevant to the process of ratifying and monitoring strategic decisions. They are decision agents who differ from other such agents on the board on this inside information dimension: they have a better opportunity to observe the senior manager and evaluate his or her decisions. The board as a whole uses the information to evaluate decision initiatives of the performance of other managers, including the top manager, in the organization. Decision controllers are directors who are decision agents in other large complex organizations. These individuals are decision experts in organiza-

6 344 / JOURNAL OF LAW, ECONOMICS. AND ORGANIZATION 11:2, 1986 tional environments similar to that of the firm upon whose board they serve. To be effective, decision controllers should generally have an active managerial affiliation with a large complex organization in order to have the general expertise to ratify and monitor decisions and have the incentive to hire, fire and compensate top management. For present purposes, only active business executives in large complex organizations will be classified as decision controllers. Operationally, an outside director will be included in this category if he or she is affiliated with afirmlarge enough to be included in the Fortune 1000 industrial firms or Fortune 250 service sector organizations. This cutoff criterion may be arbitrary, but it reflects adequately the belief that effective decision controllers will be affiliated with large complex organizations. In addition, directors who are also owners of the firm will be included on the belief that while they may not be decision experts, they certainly will be motivated to effectively monitor the decision managers. Decision supporters are individual directors who provide expertise in capital markets, corporate law, or other relevant technologies, not primarily related to the decison control function. They provide an important support function to the firm's senior management in dealing with various strategy formulation and implementation problems. They may also serve as decision controllers and as symbolic directors (for example, the local banker or a retired lawyer living in the community where the firm is headquartered), but their primary value to thefirmis this support function. Operationally, directors will be classified as decision supporters if they are affiliated withfinancialinstitutions, law firms, advertising agencies, or accounting or consultingfirms.they may be active members of these firms, directors, or retired members to qualify for inclusion in this category. Since this category does not play a role, a priori, in the present analysis of corporate governance, it is included simply to classify the firm's directors completely. Symbolic or stakeholder representatives are directors who are not properly classified as decision managers, controllers, or supporters. Such individuals may be included on boards to represent the interests of the local community, workers, consumer interests, and so forth. Individuals may also be included on the board to add legitmacy to the organization (a clergyman, for example) or to symbolize the organization's commitment to various "social" goals (for example, minorities or women). Operationally, directors will simply be classified as symbolic or stakeholder representatives if they do not qualify for inclusion in any of the previously discussed categories. Information for the classification of directors was derived variously from annual reports, publicfilingswith the Securities and Exchange Commission, Standard and Poors' Register of Corporations, and Dun and Bradstreet's Reference Book of Corporate Managements, all with reference to the year 1983.

7 TECHNOLOGY, RESIDUAL CLAIMANTS, & CORPORATE CONTROL / COMPARATIVE ANALYSIS AND RESULTS Results of comparing the mean percentage of directors filling each of the classes discussed above across regulated and unregulated firms are presented in table 1. The table also reports the values of several covariates. In each case the comparison of means by f-statistic was corrected for potentially unequal variances between the two samples (the Behrens-Fisher problem). As shown in the table, there appeared in this sample to be significant differences in the composition of utility and general industrial firms, as predicted. Moreover, the differences generally line up with reasoning out of the comparative framework. The boards of regulated utilities have a lower percentage of internal decision agents, important external decision agents, and expert decision support directors than do unregulated firms. Utilities also have a much higher percentage of symbolic directors who probably do not supply decision control services to the firm. These results conform to expectation. These simple comparisons tend to support the view that boards are more important governance structures in unregulated firms than in public utilities; however, they have not been controlled for the confounding effects of covariates. For example, if unregulated firms tended to be headquartered in large metropolitan areas while utilities were generally located in rural areas, the greater proportion of important external decision agents found on the board of unregulated firms might be explained simply by the greater availability of eligible candidates. To correct for such potential confounds, multivariate techniques were used to adjust the means reported in table 1 and correct for the spurious effects of several of these confounds. The results presented in table 1 were so checked by regressing a discrete independent variable on various measures of board composition, holding Table 1. Results of Difference in Means Tests Variable Decision managers Decision controllers Decision supporters Symbolic directors Covariates Total revenues ($MM) Organizational complexity proxy Local director pool proxy Regulated N = Mean Utilities 132 S.D T-stat 6.49** 5.39** 2.08* 12.16** -2.83** ** General Manufacturers N= 120 Mean S.D p <.05; "p <.01

8 346 / JOURNAL OF LAW, ECONOMICS, AND ORGANIZATION 11:2, 1986 constant several covariates. The discrete dummy variable employed in this procedure assumed a value of unityforobservations in the set of public utility firms and zero for observations in the set of general industrial firms. A negative value on this Basic Term indicates that the mean for the respective dependent variable, after partialing out the effect of the covariates, was higher on average for the general industrial firms. Measures of organizational complexity, organizational size, and the available pool of decision experts were used as covariates. The use of these variables in no way suggests a model of board composition; but they are included only to attempt to isolate the effect of the existence or absence of utility regulation on director selection outcomes. A measure of organizational complexity was included in the analysis because as organizations grow more complex, the information needed by outside directors to ratify and monitor managerial conduct may increase. Organizational complexity was proxied by the total number of senior officers the firm employed as listed by Dun and Bradstreet's Reference Book of Corporate Managements. A measure of the availability of director talent was included to correct for the possibility that the proportion of expert directors serving on the board was supply-rather than demand-driven. That is, if utility firms happened to be located disproportionately in rural areas (where the availability of important decision experts was presumed to be lower than in urban areas), simple comparisons of the proportion of such directors between regulated and unregulated firms would be confounded. The available talent pool was proxied by the number of large business establishments located within the sample firm's Standard Metropolitan Statistic Area as reported by the Commerce Department's Census of Manufacturers. Unfortunately, the most recent data available were for We suspect, however, no major changes in the relative number of large business establishments across SMSAs between 1979 and Finally, the firm's total revenue was included as a covariate to correct for the possible effect of ability to pay directors on the proportion of various director categories observed in the sample. Regardless of the need to safeguard shareholders' interests, smallerfirmsmay be less able than their larger counterparts to attract the important decision experts they require. Total revenue data were gathered from Moody's Industrial Manual. The results of the regression analyses are presented in table 2. The equations estimated used proportions as dependent variables. Consequently, it would be inappropriate to use a linear probability model to estimate the equations, since the predicted probabilities generated could lie outside the zero to one range implied by the dependent variable proportions. To correct this problem a logit model was used: the dependent variable was

9 TECHNOLOGY, RESIDUAL CLAIMANTS, & CORPORATE CONTROL / 347 Table 2. Regression Results Independent variables* Decision makers' 1 Dependent Decision controllers' 1 variables Decision supporters h Symbolic directors'* Basic term c -.39** -.24** ** Total revenues ((MM) Local director pool size (1000) Organizational complexity F R 2 a. Standardized beta's b. Entered as log p/1 c. Dummy variable (1 p <.05, "p < 01 reported **.15 "Pi)- = regulated utility)..16" -.12*.17** 8.48** * * **.24 entered into the equations as the logarithm of each category proportion, divided by one minus this proportion [log(p/l - p)}. Of course, this procedure does not correct for the likely effects of heteroskedasticity. Consequently, while the results presented in table 2 are for unadjusted data, supplementary weighted least squares regression were run with the weight equal to the square root of the product of board size multiplied by each category proportion times one minus that proportion. This serves the corrective purpose since the variance of the logit random error is the reciprocal of this value (Amemiya). The sign and significance of the basic terms were not affected by this corrective, and, hence, the unweighted results are reported. As table 2 demonstrates, the results of simple comparative analysis were generally confirmed by multivariate analysis. The basic terms are the same sign as in table 1 and (with the exception of the equation for decision support directors) significant despite correcting for various potential confounds. We do not know why the proportion of lawyers,financial experts, consultants, and the like serving on the boards of regulated and unregulated firms is approximately equal. Perhaps such directors serve to support managerial decision making with expertise rather than primarily to safeguard shareholders' interests. If so, the absence of significant differences in their representation on boards of utilities and general industrial firms is not surprising. Regardless, the results of both simple and multivariate comparisons demonstrate that board composition reflects the differential hazards faced by shareholders in two distinct institutional environments.

10 348 / JOURNAL OF LAW, ECONOMICS, AND ORGANIZATION 11:2, SUMMARY AND CONCLUSIONS There have been few theoretical or empirical attempts to analyze the structure and composition of the board as an economic (or costly) input employed in the production process of controlling decision managers. The basic idea advanced in this paper has been that the control over hired decision managers is the result of a combination of governance mechanisms. We maintain that changes in any mechanism will produce predictable changes in others. Corporate law requires that all publicly traded corporations have a board of directors; our discussion suggests that the composition of the board differs between regulated firms and unregulated firms, ceteris paribus. In effect, corporations contract around law by constructing economical boards where the law may be redundant. The proportion of high-priced directors who are either internal decision managers or decision makers in other large, complex organizations was found to be smaller in regulated firms than in unregulated firms, ceteris paribus. Regulated firms, however, employ a higher proportion of less costly, non-business-affiliated board members whose task is to promote the social image of the firm. REFERENCES Alchian. A. A "Corporate Management and Property Rights," In H. G. Manne, ed., Economic Policy and Regulation of Corporate Securities. Washington, D.C.: American Enterprise Institute for Public Policy Research. Alchian, A. A., and H. Demsetz "Production, Information Costs, and Economic Organizaiton," 62 American Economic Review 777. Amemiya, T "Qualitative Response Models: A Survey," 19Journal of Economic Literature Baysinger, B., and H. Butler. 1985a. "Corporate Goverance and the Board of Directors: Performance Effects of Changes in Board Composition," I Journal of Law, Economics, and Organization b. "The Role of Corporate Law in the Theory of the Firm." 28 Journal of Law and Economics 179. Chandler, A. D Strategy and Structure: Chapters in the History of American Industrial Enterprise. Cambridge, Mass.: MIT Press. Demsetz, H "The Structure of Ownership and the Theory of the Firm," 26 Journal of Law and Economics 375. Department of Commerce Census of Manufacturers. Dun and Bradstreet, Inc Reference Book of Corporate Management. Easterbrook, F. H 'Two Agency-Cost Explanations of Dividends," 74 American Economic Review 650. Easterbrook, F. H., and D. R. Fischel "Corporate Control Transactions," 91 Yale Law Journal 698. Eisenberg, M The Structure of the Corporation. Boston, Mass.: Little, Brown, and Company. Faith, R., R. S. Higgins, and R. Tollison "Managerial Rents and Outside Recruitment in the Coasian Firm," 74 American Economic Review 660. Fama, E. F "Agency Problems and the Theory of the Firm." 88 Journal of Political Economu 288.

11 TECHNOLOGY, RESIDUAL CLAIMANTS, & CORPORATE CONTROL / 349 Fama, E. F., and M. C. Jensen. 1983a. "Agency Problems and Residual Claims," 26 Journal of Law and Economics b. "Separation of Ownership and Control." 26 Journal of Law and Economics 301. Henn. H. C The Law of Corporations. St. Paul: West Publishing Co. Jensen, M. C, and W. C. Meckling "Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure," 3 Journal of Financial Anayhis 305. Marine, Henry G "Mergers and the Market for Corporate Control," 73 Journal of Political Economy 110. Mizruchi, M. S "Who Control Whom? An Examination of the Relation between Management and Boards of Directors in Large Corporations," 8 Academy ofmanagi ment Review 426. Moody Industrial Manual. Wilcox, C, and G. Shepherd Public Policies towards Business. Homewood, 111.: Richard D. Irwin. Williamson, O. E Corporate Control and Business Behavior: Managerial Objectives in a Theory of the Firm. Englewood Cliffs: Prentice-Hall "The Modern Corporation: Origins, Evolution, Attributes," 19 Journal of Economic Literature "Organization Form, Residual Claimants, and Corporate Control," 26 Journal of Law and Economics "Corporate Governance," 93 Yale Law Journal 1197.