Professor Bainbridge...on law, politics, religion, culture & food

Board size: Is there an optimum?

In the extensive commentary on the NYSE’s governance problems, a point I have not seen discussed very much is the sheer size of the NYSE board.

Board sizes vary widely. But most public corporation boards are much smaller than the NYSE’s 27 members. A 1999 survey by the National Association of Corporate Directors (NACD) found that slightly less than half of corporate boards had seven to nine members, with the remaining boards scattered evenly on either side of that range.

Is there an optimal board size? One meta-analysis of studies of board size in particular found a statistically significant correlation between increased board size and improved financial performance. Dan R. Dalton, Number of Directors and Financial Performance: A Meta-Analysis, 42 Acad. Mgmt. J. 674, 676 (1999). Given the potential influence of confounding variables, however, it does not seem safe to draw firm conclusions from that survey. Other studies, moreover, are to the contrary. See, e.g., Sanjai Bhagat & Bernard Black, The Uncertain Relationship Between Board Composition and Firm Performance, 54 Bus. Law. 921, 941-42 (1999) (summarizing studies); Theodore Eisenberg et al., Larger Board Size and Decreasing Firm Value in Small Firms, 48 J. Fin. Econ. 35, 36 (1998) (finding a significant negative correlation between board size and firm profitability in small and medium Finnish firms).

Up to a certain point, large boards can have a number of benefits. Larger size may facilitate the board’s resource-gathering function, since a larger number of directors will usually translate into more interlocking relationships with other organizations that may be useful in providing resources such as customers, clients, credit, and supplies. Larger boards with diverse interlocks are also likely to include a greater number of specialists—such as investment bankers or attorneys—who bring special expertise to the table.

On the other hand, a number of considerations suggest that small boards may be preferable. Large boards tend to be contentious and fragmented, which would reduces their ability collectively to monitor and discipline senior management. In such cases, the senior managers can affirmatively take advantage of the board through “coalition building, selective channeling of information, and ‘dividing and conquering.’ ” Jeffrey A. Alexander et al., Leadership Instability in Hospitals: The Influence of Board-CEO Relations and Organizational Growth and Decline, 38 Admin. Sci. Q. 74, 79 (1993). There seems to be plenty of evidence of this phenomenon at the NYSE under Grasso.

The social loafing phenomenon also suggests an upper limit on efficient group size. In a famous 1913 study which measured how hard subjects pulled a rope, members of two-person teams pulled to only ninety-three percent of their individual capacity, members of trios pulled to only eighty-five percent, and members of groups of eight pulled to only forty-nine percent. See David A. Kravitz & Barbara Martin, Ringelmann Rediscovered: The Original Article, 50 J. Personality & Soc. Psychol. 936, 938 (1986). This phenomenon is partially attributable to the difficulty of coordinating group effort as size increases. (Too many cooks spoil the soup.) Social loafing is also attributable, however, to the difficulty of motivating members of a group where identification and/or measurement of individual productivity are difficult—i.e., where the group functions as a production team. As group size grows, for example, the number of nonparticipants (loafers) likely increases. In addition, larger boards may inhibit the formation of the sorts of close-knit relationships by which groups constrain agency costs.

On balance, my guess is that 27 is way too big for optimal board functioning. A Korn/Ferry survey of corporate directors found: "According to respondents, the optimal board size is two inside directors and eight outside." So add this to the list of necessary NYSE reforms.

What is the appropriate motivation for director nominees?

Over at TheCorporateCounsel.net Blog, Broc poses the titular question, and comments:

One aspect of boardroom reform that has not been fully explored is what should be an acceptable motivation for someone who seeks to serve as a director. Historically, directors have agreed to serve principally for the prestige and clublike atmosphere. Some have done it for the money - although this is unlikely the case for those directors that earn big dollars as officers at other companies.

At the recent BRT Roundtable on Corporate Governance, Fannie Mae CEO Franklin Raines explained that he joined Pfizer's board to enhance his ability to be an innovator - which in turn would benefit his employer. This is an honest and understandable answer - but does it serve the needs of Pfizer's shareholders to whom he now owes fiduciary duties?

Personally, I think you want directors motivated by precisely what motivated Raines -- i.e., healthy self-interest. In The Wealth of Nations, Adam Smith famously remarked:

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages. [Book I, Chap.2.]

[In the course of conducting business, a business person generally] neither intends to promote the public interest, nor knows how much he is promoting it. [Instead, the business person] intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. [Book IV, Chap. 2.]

Of course, Smith also famously railed against joint stock companies, which we now know to be error, but even mighty Homer nods.

Independent directors are not a panacea for the ills of corporate governance, as I have argued elsewhere, but independent directors motivated by a healthy concern for the self-interest do have considerable incentives to actively monitor management and to discipline poor managers. If the company fails on their watch, for example, the independent directors’ reputation and thus their future employability is likely to suffer. Those incentives are not perfect, of course, as demonstrated by the failures of independent directors at Enron and its ilk. But no motivation besides self-interest is more likely to elicit whatever benefits director independence can provide.

The fallout from Grasso? How about more worthless disclosure?

How will public corporations respond to the Grasso imbroglio? The New York Times speculates:

Directors of big companies, already under pressure to demonstrate independence from management, are now worried that they will be blamed for failing to explain not only how much but how they pay chief executives. ...

When companies send proxy statements to shareholders early next year, [Tom Wamberg, chief executive of Clark Consulting] said, they will be noticeably thicker, because directors feel compelled to spell out the terms of the deals they have struck with company officers.

"Our advice to our clients is overcommunicate, overexplain," Mr. Wamberg said. "For each required disclosure, what could have been four paragraphs is going to be eight paragraphs."

Wamberg's prediction strikes me as just about right. Risk averse lawyers will not want to be blamed by their clients if the firm gets bad PR for inadequate disclosure, let alone getting sued (successfully or not). Risk averse directors would rather provide excess disclosure than risk the sort of harm to their reputation that the NYSE's directors are currently experiencing. But is extra disclosure a good thing?

A rational shareholder will expend the effort to make an informed decision only if the expected benefits of doing so outweigh its costs. Given the length and complexity of SEC disclosure documents, the opportunity cost entailed in becoming informed before voting is quite high and very apparent. Moreover, most shareholders' holdings are too small to have any significant effect on the vote's outcome. Accordingly, shareholders assign a relatively low value to the expected benefits of careful consideration. (For a discussion of why rational apathy is a good thing, see HERE.)

The SEC has consistently ignored these textbook principles, insisting that shareholders want more and better disclosure of executive compensation. Ultimately, however, more comprehensible information doesn't help and greater volumes of information only makes the situation worse. For most shareholders, the investment of time and effort necessary to make informed voting decisions remains a game that is not worth playing. What then will shareholders do with the enhanced disclosure they will be getting post-Grasso? They will do what they always do with corporate disclosure: ignore it and simply vote for management's director slate and management compensation proposals.

Some believe that this shareholder passivity model no longer holds true in light of the growing importance of institutional investors. To be sure, institutional investors are an increasingly important force in the stock markets and, moreover, some institutions are playing a more active role in corporate governance. At the same time, however, the passivity model undoubtedly remains applicable even to most institutional investors. Participating in corporate governance is not a cost-less endeavor. Just as with any other shareholder, institutional investors must expend resources to make informed decisions. Most institutional investors therefore will probably seek to free-ride on the efforts of the few who are willing to expend such resources. As is typical of free-riding situations, this means that virtually no one will make informed decisions.

In sum, shareholders will want boards to make cost-effective disclosures. They will not want the board to spend a dollar on disclosure unless the shareholders get back at least $1.01 worth of additional value in the form of more informed decisions, greater accountability, and additional transparency. My guess is that Wamberg is right, and that many corporations will be spending a lot more on disclosure than the value the shareholders will get back.

Random stock traders and the ECMH; with a review of Malkiel’s Random Walk

An article in Nature claims: "Stock market traders show signs of zero intelligence." It reports on research by J. Doyne Farmer, of the Santa Fe Institute, which purports to find that "that economic decision-making is so varied and complex that it is hard to distinguish it from random choices." They set up a theoretical model that assumes "traders place orders at random rather than on the basis of shrewd calculation and observation of economic trends." The results of running that model replicate many of the statistical features of a real world stock market (the London Stock Exchange in the period 1998-2000). Not being a fan of theoretical modeling, I find this result less persuasive than if it were backed by actual empirical data on ivestor behavior. (Link via Tyler at Marginal Revolution.)

The efficient capital markets hypothesis has long claimed that stock price movements are random. But in the ECMH model randomness refers not to trader behavior but to the proposition that stock price movements are serially independent. Randomness does not mean that the stock market is like throwing darts at a dart board. Stock prices go up on good news and down on bad news. If a company announces a major oil find, all other things being equal, the stock price will go up. Randomness simply means that stock price movements are serially independent: future changes in price are independent of past changes. In other words, investors can not profit by using past prices to predict future prices. Randomness in the ECMH thus is not inconsistent with the proposition that stock market actors are informed rational self-maximizers. In contrast, Nature claims that Farmer's research is inconsistent with that proposition: "by dispensing with even a restricted form of rationality, the new model is daring"

Like Tyler, I think Nature overstates the extent to which the standard ECMH model requires hard assumptions of rationality on the part of investors. Much recent work has been done on incorporating insights from noise theory and behavioral finance into the ECMH. (See also HERE.) Most economists simply do not believe in the extreme version of the ECMH that Nature lays out (as the Nature article itself acknowledges). To this extent, the article is arguing against a strawman. Instead, most economists and economically-minded lawyers who still adhere to ECMH now fall back on the old rule that "it takes a theory to beat a theory." In this view, the ECMH is a first approximation that does a better job of predicting market behavior than any other theory out there. When a theory comes along that generates profitable trading strategies inconsistent with ECMH that will be the day that the ECMH has been disproved. But this study is not that theory.

For more information on the ECMH, as well as a review of the best book ever written on using finance theory as an investment guide, see the extended post.

In RANDOM WALK DOWN WALL STREET, Burton Malkiel sets out the basics of modern corporate financial theory in a way accessible to the law reader. As a teacher of corporate finance to law students, I have recommended this book to my students for over 10 years. Numerous alumni have told me that was the best advise they got in law school (a sad commentary on American legal education, but that's another story).

Two basic theories are expounded here. First, modern portfolio theory (MPT), which elucidates the relationship between risk and diversification. Because investors are risk averse, they must be paid for bearing risk, which is done through a higher expected rate of return. As such, we speak of a risk premium: the difference in the rate of return paid on a risky investment and the rate of return on a risk-free investment. In the real world, we measure the risk premium associated with a particular investment by subtracting the short-term Treasury bill interest rate from the risky investment's rate of return. The risk premium, however, will only reflect certain risks. MPT differentiates between two types of risk: unsystematic and systematic. Unsystematic risk might be regarded as firm-specific risk: The risk that the CEO will have a heart attack; the risk that the firm's workers will go out on strike; the risk that the plant will burn down. These are all firm-specific risks. Systematic risk might be regarded as market risk: risks that affect all firms to one degree or another: changes in market interest rates; election results; recessions; and so forth. MPT acknowledges that risk and return are related: investors will demand a higher rate of return from riskier investments. In other words, a corporation issuing junk bonds must pay a higher rate of return than a company issuing investment grade bonds. Yet, portfolio theory claims that issuers of securities need not compensate investors for unsystematic risk. In other words, investors will not demand a risk premium to reflect firm-specific risks. Why? There is a mathematical proof, which relates to variance and standard deviation, but Malkiel explains it in a way that is quite intuitive. Investors can eliminate unsystematic risk by diversifying their portfolio. Diversification eliminates unsystematic risk, because things tend to come out in the wash. One firm's plant burns down, but another hit oil. Thus, even though the actual rate of return earned on a particular investment is likely to diverge from the expected return, the actual return on a well-diversified portfolio is less likely to diverge from the expected return. Bottom line? If you hold a nondiversified portfolio (say all Internet stocks), you are bearing risks for which the market will not compensate you. You may do well for a while, but it will eventually catch up to you (as it has recently for tech stocks).

The second pillar of Malkiel's analysis is the efficient capital markets theory (ECMH). The fundamental thesis of the ECMH is that, in an efficient market, current prices always and fully reflect all relevant information about the commodities being traded. In other words, in an efficient market, commodities are never overpriced or underpriced: the current price will be an accurate reflection of the market's consensus as to the commodity's value. Of course, there is no real world condition like this, but the securities markets are widely believed to be close to this ideal. There are three forms of ECMH, each of which has relevance for investors: **Weak form: All information concerning historical prices is fully reflected in the current price. Price changes in securities are serially independent or random. What do I mean by "random"? Suppose the company makes a major oil find. Do I mean that we can't predict whether the stock will go up or down? No: obviously stock prices generally go up on good news and down on bad news. What randomness means is that investors can not profit by using past prices to predict future prices. If the Weak Form of the hypothesis is true, technical analysis (a/k/a charting)-the attempt to predict future prices by looking at the past history of stock prices-can not be a profitable trading strategy over time. And, indeed, empirical studies have demonstrated that securities prices do move randomly and, moreover, have shown that charting is not a long-term profitable trading strategy. ** Semi-Strong Form: Current prices incorporate not only all historical information but also all current public information. As such, investors can not expect to profit from studying available information because the market will have already incorporated the information accurately into the price. As Malkiel demonstrates, this version of the ECMH also has been well established by empirical studies. Implication: if you spend time and effort studying stocks and companies, you are wasting your time. If you pay somebody to do it for you, you are wasting your money. ** Strong Form holds that prices incorporate all information, publicly available or not. This version must be (and is) false, or insider trading would not be profitable.

In the last section of RANDOM WALK, Malkiel distills all this theory into an eminently practical life-cycle guide to investing. As one may infer, it has two basic principles. First, diversification. Second, no one systematically earns positive abnormal returns from trading in securities; in other words, over time nobody outperforms the market. Mutual funds may outperform the market in 1 year, but they may falter in another. Once adjustment is made for risks, every reputable empirical study finds that mutual funds generally don't outperform the market over time. Malkiel's recommendation: put your money into no-load passively managed index mutual funds. You will see lots of anonymous reviews of RANDOM WALK claiming Malkiel is wrong. Odds are, most of those folks are have either been misled by the long bull market or, even more likely, are brokers or other market professionals who make a living selling active portfolio management. In sum, buy it, read it, believe it, and practice it.

Review:  A Theory of the Firm: Governance, Residual Claims, and Organizational Forms by Michael C. J

Michael Jensen is one of the founders of the agency cost economics branch of the New Institutional Economics. A Theory of the Firm collects eight articles by Jensen and various co-authors that, collectively, represent the seminal body of work in this field. (I wonder how his various co-authors felt about being left of the spine of this book?) While his contributions to agency cost theory are the work for which he is best known, Jensen also figures prominently in the intellectual history of the nexus of contracts theory of the firm, as several of the articles collected here demonstrate.

The SEC’s lobster trap

Mike O'Sullivan has an interesting post at Corp Law Blog on Rule 12h-3 and 12g5-1. The proposed changes he discusses would make it more difficult for corporations to extricate themselves from the SEC's periodic disclosure requirements, thereby perhaps also discouraging marginal firms from going public in the first place. If the securities laws are like a lobster trap, as some argue, these changes would further strengthen the analogy.

Alex Tabarrok on Executive Compensation

Alex Tabarrok blogs at Marginal Revolution on executive compensation:

If workers are paid their marginal product its difficult to understand why some CEOs are paid such high wages. But think of the CEO's wage as a prize. Valuable prizes make everyone else work hard in order to become the CEO. With this model, the tournament model (JSTOR) of Lazear and Rosen, it may even make sense that CEO wages go up as profits go down. After all, shouldn't prizes be set highest when motivation is most required? No doubt, some will see this argument as more proof that economists are just shills for the capitalist class.

Good point. For my take on executive compensation, which some will also see as shilling for the capitalist oppressors, see Marginal Revolution on Grasso and Al Hunt on Grasso and the NYSE.

UPDATE: Corp Law Blog chimes in too, citing a study by two economists (non-Marginal Revolutionaries):

If you work at a bad firm, you are less likely to become a CEO because the firm is less likely to be around when you reach the finish line. Even if you become CEO, you should expect a shorter tenure than at a good firm, as your results are likely to be poor and as a result you're more likely to fired. Therefore, the bad firm has to pay its CEO more in order to induce you to shoot for its higher-risk CEO prize.

Sounds about right to me.

Review and Comment: Ronald Coase, The Firm, the Market, and the Law

Lawrence Solum has an excellent post today on Nobel laureate economist Ronald Coase and the famous Coase theorem. The Coase theorem is a principal foundation of modern neoclassical law and economics, of course; indeed, arguably the principal foundation. Solum's post is highly recommended.

Solum's post reminded me that I have been meaning to review Coase's book The Firm, The Market, and the Law. This is principally a collection of Coase's seminal works, although it does contain some useful new material. In particular, the opening chapter is entirely new and shows how a consistent theory of firms and markets, as well as a unique conception of economics and economically-oriented scholarship, runs through Coase's work from the 1930s to the late 1980s (when the book was published).