Corporate Governance
Journal of Banking & Finance 22 (1998) 371±403
Corporate governance and board eectiveness
Kose John a, Lemma W. Senbet a b
1
b,*
Stern School of Business, New York University, New York, NY 10012, USA Department of Finance, College of Business, University of Maryland, Tydings Hall, College Park, MD 20742, USA
Abstract This paper surveys the empirical and theoretical literature on the mechanisms of corporate governance. We focus on the internal mechanisms of corporate governance (e.g., corporate board of directors) and their role in ameliorating various classes of agency problems arising from con¯icts of interests between managers and equityholders, equityholders and creditors, and capital contributors and other stakeholders to the corporate ®rm. We also examine the substitution eect between internal mechanisms of corporate governance and external mechanisms, particularly markets for corporate control. Directions for future research are provided. Ó 1998 Elsevier Science B.V. All rights reserved. JEL classi®cation: G30; G32 Keywords: Corporate governance; Corporate ®nance; Internal and external mechanisms of corporate governance
``Eorts to reform company government have concentrated on making managers afraid. It is time now to make boards greedy ' ' [The Economist, August 9, 1997]
* 1
Corresponding author. Tel.: 1 301 405 2242; e-mail: lsenbet@mbs.umd.edu. This paper was an invited paper on the occasion of the JBF 20th anniversary.
0378-4266/98/$19.00 Ó 1998 Elsevier Science B.V. All rights reserved. PII S 0 3 7 8 - 4 2 6 6 ( 9 8 ) 0 0 0 0 5 - 3
372
K. John, L.W. Senbet / Journal of Banking & Finance 22 (1998) 371±403
1. Introduction Corporate governance deals with mechanisms by which stakeholders of a corporation exercise control over corporate insiders and management such that their interests are protected. The stakeholders of a corporation include equityholders, creditors and other claimants who supply capital, as well as
Corporate governance and board eectiveness
Kose John a, Lemma W. Senbet a b
1
b,*
Stern School of Business, New York University, New York, NY 10012, USA Department of Finance, College of Business, University of Maryland, Tydings Hall, College Park, MD 20742, USA
Abstract This paper surveys the empirical and theoretical literature on the mechanisms of corporate governance. We focus on the internal mechanisms of corporate governance (e.g., corporate board of directors) and their role in ameliorating various classes of agency problems arising from con¯icts of interests between managers and equityholders, equityholders and creditors, and capital contributors and other stakeholders to the corporate ®rm. We also examine the substitution eect between internal mechanisms of corporate governance and external mechanisms, particularly markets for corporate control. Directions for future research are provided. Ó 1998 Elsevier Science B.V. All rights reserved. JEL classi®cation: G30; G32 Keywords: Corporate governance; Corporate ®nance; Internal and external mechanisms of corporate governance
``Eorts to reform company government have concentrated on making managers afraid. It is time now to make boards greedy ' ' [The Economist, August 9, 1997]
* 1
Corresponding author. Tel.: 1 301 405 2242; e-mail: lsenbet@mbs.umd.edu. This paper was an invited paper on the occasion of the JBF 20th anniversary.
0378-4266/98/$19.00 Ó 1998 Elsevier Science B.V. All rights reserved. PII S 0 3 7 8 - 4 2 6 6 ( 9 8 ) 0 0 0 0 5 - 3
372
K. John, L.W. Senbet / Journal of Banking & Finance 22 (1998) 371±403
1. Introduction Corporate governance deals with mechanisms by which stakeholders of a corporation exercise control over corporate insiders and management such that their interests are protected. The stakeholders of a corporation include equityholders, creditors and other claimants who supply capital, as well as
References: Agrawal, A., Knoeber, C., 1996. Firm performance and mechanisms to control agency problems between managers and shareholders. Working paper, Wharton School. Bange, M., Mazzeo, M., 1996. Board composition, board e€ectiveness and the observed form of takeover bids. Working paper. Michigan State University, East Lansing, MI. Barnea, A., Haugen, R., Senbet, L., 1985. Agency Problems and Financial Contracting, PrenticeHall, Englewood Cli€s, NJ. Baysinger, B., Butler, H., 1985. Corporate governance and board of directors: performance e€ects of changes in board composition. Journal of Law, Economics and Organization 1, 101±124. Bebchuk, L., 1988. A new method for corporate reorganization. Harvard Law Review 101, 775± 804. Berglof, E., 1994. The governance structure of the Japanese ®nancial kieretsu. Journal of Financial Economics 36, 259±284. Bhagat, S., Black, B., 1996. Do independent directors matter? Working paper. Columbia University, New York. Bhagat, S., Black, B., 1997. Board composition and ®rm performance: The uneasy case for majority-independent boards. Working paper. Columbia University, New York. Brander, J., Lewis, T., 1986. Oligopoly and ®nancial structure: The limited liability e€ect. American Economic Review 76, 956±970. Brickley, J., James, C., 1987. The takeover market, corporate board composition, and ownership structure: The case of banking. The Journal of Law and Economics 161±181. Brickley, J., Coles, J., Terry, R.L., 1994. Outside directors and the adoption of poison pills. Journal of Financial Economics 35, 371±390. Chang, C., 1995. Performance-based compensation and outside interventions as alternative incentive mechanisms and the commitment role of the board. Working paper. University of Minnesota, Minneapolis, MN. Chidambaran, N.K., John, K., 1997. Relationship investing and corporate governance. Working paper. New York University, New York. Demsetz, H., 1983. The structure of ownership and the theory of the ®rm. Journal of Law and Economics 26, 375±390. Demsetz, H., Lehn, K., 1985. The structure of corporate ownership: Causes and consequences. Journal of Political Economy 93, 1155±1177. Diamond, D.W., 1991. Monitoring and reputation: The choice between bank loans and directly placed debt. Journal of Political Economy 99, 688±721. Easternbrook, F., Fischel, D., 1991. The Economic Structure of Corporate Law. Harvard University Press, Cambridge, MA. Fama, E., Jensen, M., 1983. Separation of ownership and control. Journal of Law and Economics 26, 327±349. Franks, J., Mayer, C., 1994. The ownership and control of German corporations. Working paper. Business School. Fosberg, R., 1989. Outside directors and managerial monitoring. Akron Business and Economic Review 20, 24±32. Gale, D., Hellwig, M., 1985. Incentive compatible debt contracts: One period problem. The Review of Economic Studies 26, 327±349. Gertner, R., Scharfstein, D., Stein, J., 1994. Internal versus external capital markets. Quarterly Journal of Economics 109, 1211±1230. Gilson, S., 1990. Bankruptcy, boards, banks, and blockholders. Journal of Financial Economics 27, 355±387. Green, R.C., 1984. Investment incentives, debt, and warrants. Journal of Financial Economics 13, 115±136. 402 K. John, L.W. Senbet / Journal of Banking & Finance 22 (1998) 371±403 Grossman, S., Hart, O., 1980. Takeover bids, the free-rider problem, and the theory of the corporation. Bell Journal of Economics 11, 42±64. Harris, M., Raviv, A., 1988. Corporate governance: Voting rights and majority rules. Journal of Financial Economics 20, 203±235. Hart, O., Moore, J., 1989. Default and renegotiation: A dynamic model of debt. Working paper. Harvard University, Cambridge, MA. Haugen, R., Senbet, L., 1978. The insigni®cance of bankruptcy costs to the theory of optimal capital structure. Journal of Finance 33, 383±393. Haugen, R., Senbet, L., 1988. Bankruptcy and agency costs: Their signi®cance to the theory of optimal capital structure. Journal of Financial and Quantitative Analysis 23, 27±38. Hermalin, B., Weisbach, M., 1997. Endogenously chosen boards of directors and their monitoring of the CEO. American Economic Review, forthcoming. Hermalin, B., Weisbach, M., 1988. The determinants of board composition. RAND Journal of Economics 19, 589±606. Hermalin, B., Weisbach, M., 1991. The e€ects of board composition and direct incentives on ®rm performance. Financial Management 101±112. Hirshleifer, D., Thakor, A., 1994. Managerial performance, boards of directors and takeover bidding. Journal of Corporate Finance 1, 63±90. Holderness, C., Sheehan, D., 1988. The role of majority shareholders in publicly held corporations. Journal of Financial Economics 20, 317±346. Jensen, M., 1989. Active investors, LBOs and the privatization of bankruptcy. Journal of Applied Corporate Finance 2, 35±44. Jensen, M., 1993. The modern industrial revolution, exit, and the failure of internal control systems. Journal of Finance 48, 831±880. Jensen, M., Meckling, W., 1976. Theory of the ®rm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics 48, 831±880. Jensen, M., Murphy, K., 1990. Performance pay and top-management incentives. Journal of Political Economy 98, 225±264. Jensen, M., Warner, J.B., 1988. The distribution of power among corporate managers, shareholders, and directors. Journal of Financial Economics 20. John, K., 1993. Managing ®nancial distress: A survey and a research agenda. Financial Management, Autumn. John, T.A., John, K., 1993. Top-management compensation and capital structure. Journal of Finance 48, 949±974. John, K., Senbet, L., 1996. Limited liability, corporate leverage, and public policy. Working paper. New York University. John, K., John, T., Senbet, L., 1991. Risk-shifting incentives of depository institutions: A new perspective on federal deposit insurance reform. Journal of Banking and Finance 15, 895± 915. John, K., Saunders, A., Senbet, L.W., 1997. A theory of bank regulation and management compensation. Working paper. University of Maryland and New York University. John, K., Senbet, L.W., Sundaram, A.K. (1994). Corporate limited liability and the design of corporate taxation. Unpublished paper. University of Maryland and New York University. Kaplan, S., 1994. Top executive rewards and ®rm performance: A comparison of Japan and the US. Journal of Political Economy 102, 510±546. Kaplan, S., 1997. The evolution of US corporate governance: We are all Henry Kravis now. Working paper. University of Chicago, Chicago, IL. Kedia, S., 1997a. Product market competition and top management compensation. Working paper. Harvard University, Cambridge, MA. Kedia, S., 1997b. Product markets and the strategic role of governance mechanisms. Working paper. Harvard University, Cambridge, MA. K. John, L.W. Senbet / Journal of Banking & Finance 22 (1998) 371±403 403 Klein, A., 1995. An examination of board committee structures. Working paper. New York University, New York. Klein, A., Rosenfeld, J., 1988. Targeted share repurchase and top management changes. Journal of Financial Economics 20, 493±506. Kini, O., Kracaw, W., Mian, S., 1995. Corporate takeovers, ®rm performance, and board composition. Journal of Corporate Finance 1, 383±412. Lipton, M., Lorsch, J., 1992. A modest proposal for improved corporate governance. Business Lawyer 59, 59±77. Mace, M., 1986. Directors, Myth, and Reality. Harvard Business School Press, Boston. Maksimovic, V., 1986. Optimal capital structure in repeated oligopolies. Rand Journal 19, 389±407. Madan, S., Senbet, L., Soubra, B., 1995. Capital structure and the design of managerial compensation. Working paper. University of Maryland, College Park, MI. Mayers, D., Shivadashani, A., Smith, C., 1997. Board composition and corporate control: Evidence from the insurance industry. Journal of Business 70 (1), forthcoming. Morck, R., Shleifer, A., Vishny, R., 1989. Alternative mechanisms for corporate control. American Economic Review 79, 842±852. Myers, S., 1977. Determinants of corporate borrowing. Journal of Financial Economics 11±41. Noe, T., Rebello, M.J., 1996. The design of corporate boards: Composition, compensation, factions, and turnover. Working paper. Georgia State University, Atlanta, GA. Park, S., Roze€, M., 1996. The role of outside shareholders, outside boards, and management entrenchment in CEO selection. Working paper. SUNY, Bu€alo, NY. Rajan, R.G., 1992. Insiders and outsiders: The choice between informed and arm 's-length debt. Journal of Finance XLVII 1367±1400. Romano, R., 1993. The Genius of American Corporate Law. American Enterprise Institute Press, Washington DC. Rosenstein, S., Wyatt, J.G., 1990. Outside directors, board independence, and shareholder wealth. Journal of Financial Economics 26, 176±191. Senbet, L., Seward, J., 1995. Financial distress, bankruptcy and reorganization. In: Jarrow, R., Maksimovic, V., Ziemba, W. (Eds.), Finance. North-Holland, Amsterdam. The New York Times, 1997. The Search for the Perfect Corporate Board. Schroder, U., Schrader, A., 1996. The changing role of banks and corporate governance in Germany: Evolution toward the market? Working paper. Deutsche Bank Research. Shleifer, A., Vishny, R., 1986. Large shareholders and corporate control. Journal of Political Economy 94, 461±488. Shleifer, A., Vishny, R., 1997. A survey of corporate governance. Journal of Finance 52, 737±775. Shivdasani, A., 1993. Board composition, ownership structure, and hostile takeovers. Journal of Accounting and Economics 16, 167±198. Stulz, R., 1988. Managerial control of voting rights. Journal of Financial Economics 20, 25±59. Townsend, R., 1979. Optimal contracts and competitive markets with costly state veri®cation. Journal of Economic Theory 21, 265±293. Warther, V., 1994. Board e€ectiveness and board dissent: A model of the board 's relationship to management and shareholders. Working paper. USC. Weisbach, M., 1988. Outside directors and CEO turnover. Journal of Financial Economics 20, 431± 460. Wenger, E., Kaserer, C., 1996. The German system of corporate governance: A model which should not be imitated. Working paper. University of Wuerzburg. Whisler, T., 1984. Rules of the Game, Dow Jones ± Irwin, Homewood, IL. Williamson, O.E., 1983. Organizational form, residual claimants, and corporate control. Journal of Law and Economics 26, 351. Yermack, D., 1996. Higher market valuation of companies with a small board of directors. Journal of Financial Economics 40, 185±211.