CORPORATE GOVERNANCE The Robert W. Kolb Series in Finance provides a comprehensive view of the field of finance in all of its variety and complexity. The series is projected to include approximately65volumescoveringallmajortopicsandspecializationsinfinance, rangingfrominvestments,tocorporatefinance,tofinancialinstitutions.Eachvol- umeintheKolbSeriesinFinanceconsistsofnewarticlesespeciallywrittenforthe volume. EachKolbSeriesvolumeiseditedbyaspecialistinaparticularareaoffinance,who develops the volume outline and commissions articles by the world’s experts in thatparticularfieldoffinance.Eachvolumeincludesaneditor’sintroductionand approximatelythirtyarticlestofullydescribethecurrentstateoffinancialresearch andpracticeinaparticularareaoffinance. 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HD2741.C774682010 338.6–dc22 2010010864 PrintedintheUnitedStatesofAmerica 10 9 8 7 6 5 4 3 2 1 Contents Acknowledgments ix PART ONE Background and Perspectives on Corporate Governance 1 History, Systems, Best Practices, and Empirical Evidence 1 AnOverviewofCorporateGovernance 3 H.KentBakerandRonaldAnderson 2 TheFinancialDeterminantsofAmericanCorporate Governance:ABriefHistory 19 LawrenceE.MitchellandDaliaT.Mitchell 3 CorporateGovernanceSystems 37 ChristianAndres,AndreBetzer,MarcGoergen,andDanielMetzger 4 CorporateGovernanceBestPractices 57 AlexTodd 5 What’sWrongwithCorporateGovernance BestPractices? 79 ChristopherSørenShannTurnbull 6 TheEffectofCorporateGovernanceonPerformance 97 SanjaiBhagat,BrianBolton,andRobertaRomano 7 InternationalCorporateGovernanceResearch 123 DianeK.Denis Separation of Ownership and Control 8 AgencyTheory:IncompleteContractingand OwnershipStructure 141 IainClacher,DavidHillier,andPatrickMcColgan 9 TheoriesandModelsofCorporateGovernance 157 ThomasW.Joo v vi Contents 10 Unfettered Agents?TheRoleofEthicsin CorporateGovernance 175 DonaldNordberg PART TWO Internal Governance 193 Boards of Directors 11 BoardCompositionandOrganizationIssues 195 MatteoTonello 12 BoardDiversity 225 DanielFerreira 13 BoardSubcommitteesforCorporateGovernance 243 ZabihollahRezaee Compensation, Ownership, and Turnover 14 ExecutiveCompensation:Incentives andExternalities 263 PhilippGeilerandLucRenneboog 15 CompensationConsultantsandExecutivePay 285 MartinJ.Conyon 16 CorporateGovernanceandOwnershipStructure 303 JohnJ.McConnell,StephenB.McKeon,andWeiXu 17 TheEffectsofManagementTurnoveron FirmPerformance 323 MarkR.HusonandRobertParrino PART THREE External Governance 345 Nonexecutive Shareholders 18 CorporateMonitoringbyBlockholders 347 IsabelleDherment-Fe´re`reandLucRenneboog 19 TheGovernanceofFamilyFirms 371 MortenBennedsen,FranciscoPe´rez-Gonza´lez,andDanielWolfenzon 20 InstitutionalandOtherShareholders 391 ChrisMallin 21 ThePoliticsofShareholderActivism 409 DonaldNordberg CONTENTS vii Nonequity Stakeholders 22 ExecutiveBehavior:ACreditorPerspectiveon ManagerialOwnership 427 RonaldAnderson,SattarMansi,andDavidReeb 23 GovernanceofBankingInstitutions 451 Rene´eBirgitAdams 24 CorporateGovernance:NonequityStakeholders 469 MarcGoergen,ChrisBrewster,andGeoffreyWood Proxy Contests and Markets 25 ProxyContests 497 PeterG.Szilagyi 26 CorporateTakeoversandRestructurings 517 MikeStegemoller 27 CorporateTakeoversandWealth Creation 535 MarinaMartynovaandLucRenneboog Accounting, Legal, and Regulatory Intervention 28 CorporateGovernanceandAccountability 559 ReneeM.Jones 29 CorporateGovernanceRulesandGuidelines 577 ZabihollahRezaee 30 EconomicsAspectsofCorporateGovernance andRegulation 599 ValentinaBrunoandStijnClaessens PARTFOUR AnswerstoChapterDiscussionQuestions 621 Index 663 Acknowledgments This book represents an ensemble of players, each providing unique con- tributions. Corporate Governance would not have been possible without the outstanding work of dozens of scholars and practitioners who wrote the chapters.Weparticularlyandgratefullyacknowledgetheirdiligentworkinpro- viding multiple revisions of each chapter. The book benefited substantially from thecapableeditorialassistanceofMeghanNesmith,whopainstakinglyreviewed thechaptersandmademanysubstantivesuggestions.Wethankourtalentedpub- lishing team at John Wiley & Sons, including Laura Walsh, Jennifer MacDonald, MichaelLisk,andmanyothers.WeappreciatethesupportprovidedbyBobKolb, theserieseditor,throughouttheprocessofproducingthisbook.Wealsowantto recognizethesupportprovidedbytheKogodSchoolofBusinessAdministrationat AmericanUniversity,especiallyDeanRichardDurandandSeniorAssociateDean Kathy Getz. Finally, we are indebted to our friends and families, who have been silentpartnersinthiseffortandhavehelpedtomakethisprojectpossible.Linda Bakerdeservesspecialthanksforherpatience,support,andediting. ix Corporate Governance: A Synthesis of Theory, Research, and Practice Edited by H. Kent Baker and Ronald Anderson Copyright © 2010 JohnWiley & Sons, Inc. PART ONE Background and Perspectives on Corporate Governance History,Systems,BestPractices,andEmpiricalEvidence Chapter1. AnOverviewofCorporateGovernance 3 Chapter2. TheFinancialDeterminantsofAmericanCorporate Governance:ABriefHistory 19 Chapter3. CorporateGovernanceSystems 37 Chapter4. CorporateGovernanceBestPractices 57 Chapter5. What’sWrongwithCorporateGovernanceBestPractices? 79 Chapter6. TheEffectofCorporateGovernanceonPerformance 97 Chapter7. InternationalCorporateGovernanceResearch 123 SeparationofOwnershipandControl Chapter8. AgencyTheory:IncompleteContractingandOwnership Structure 141 Chapter9. TheoriesandModelsofCorporateGovernance 157 Chapter10. UnfetteredAgents?TheRoleofEthicsinCorporate Governance 175 1 Corporate Governance: A Synthesis of Theory, Research, and Practice Edited by H. Kent Baker and Ronald Anderson Copyright © 2010 JohnWiley & Sons, Inc. CHAPTER1 An Overview of Corporate Governance H.KENTBAKER UniversityProfessorofFinanceandKogodResearchProfessor,AmericanUniversity RONALDANDERSON ProfessorofFinanceandGaryCohnEndowedResearchProfessor, AmericanUniversity INTRODUCTION Theimportance ofcorporate governance became dramatically clear atthebegin- ning of the twenty-first century as a series of corporate meltdowns arising from managerialfraud,misconduct,andnegligencecausedamassivelossofshareholder wealth.Thefirm’sowners(shareholders)askedwho,ifanybody,isresponsiblefor protectingandpromotingthevalueoftheirinvestment.Yetgovernanceissuesand problems have a long and sometimes shocking history. Adam Smith (1776/1904, V.1.107)wroteinWealthofNations: Beingthemanagersofotherpeople’smoneyratherthantheirown,itcannotbeexpected that they [managers] should watch over it with the same anxious vigilance which [they would]watchovertheirown.Negligenceandprofusion,therefore,mustalwaysprevail, moreorless,inthemanagementoftheaffairsofsuchacompany. Based on their seminal work, Jensen and Meckling (1976) can perhaps be credited with bringing governance issues to the forefront in the field of finance. In scholarly finance research, agency theory provides the general framework for analyzingmanagerialbehavior.Agencytheoryinitssimplestformproposesthat thefirm’sowners(principals)hiremanagers(agents)andthendelegatethefirm’s day-to-dayoperatingdecisionstothesemanagers.Thetheoryfurtherassumesthat both parties—owners and managers—seek to maximize their personal utility. In the case of shareholders, this translates into stock price (wealth) maximization. Formanagers,utilitymaximizationdoesnotnecessarilytranslateintomaximizing shareholder wealth. Managers, for instance, may prefer to focus on short-term earningsthatcorrespondwiththeirremainingtenureinthefirmratherthanlong- term earnings growth that leads to shareholder wealth maximization. Similarly, managers may seek to adopt low-risk projects that impose little personal risk 3