Codes of Best Practice in Competitive Markets for Managers

1. Codes of Best Practice in Competitive Markets for Managers Eduard Alonso-Paulí Universidad Pablo Olavide, Sevilla David Pérez-Castrillo Universitat Autònoma de Barcelona ACLE-Enforce and comply Amsterdam 6-3-2009

2. Codes of Best Practice A Code of Best Practice is a list of rules of voluntary adoption promoted by a regulator suggesting how a firm should supervise management Codes were promoted after Financial Scandals at the end of 80s. Institutions considered that these collapses were a lack of corporate governance. Committee made recommendations on “good practices”: the Cadbury Report, including a Code of Best Practice. ACLE- To Enforce and Comply

3. …Codes of Best Practice… The main recommendations of the Cadbury Report: • Separation of CEO and COB • At least three independent directors • Creation of Committees (Audit, Nomination or Remuneration) Objective?  Reduction of the power of Executive Directors (Dahya et al.,2002) ACLE- To Enforce and Comply

4. On the other hand “There is danger in an over-emphasis on monitoring; on non-executive directors' independence from the business of the corporation; on controls over decision making activities of companies. When coupled with the clearly reduced status of executives on the governing boards, such requirements must blunt the competitive edge and deflect the entrepreneurial drive which characterises participation, let alone success, in a free market.” (Sir Owen Green former BTR chairman, February 25, 1994) ACLE- To Enforce and Comply

5. Our simplified view We view a CBP as a mechanism that: • Allows the shareholder a better control of manager’s actions. • Reduces flexibility at the manager’s decision level. ACLE- To Enforce and Comply

6. Basic characteristics • Each shareholder can hire one manager to conduct her project • Success depends on manager’s effort and on market conditions • Both shareholder and manager know the (ex-ante) distribution of the market conditions • Only the manager learns the actual realization of the market conditions once the contract is signed • Agency model, but a CBP can be introduced: • No CBP: Incentive contract • CBP: The effort is contractual and fixed ex-ante ACLE- To Enforce and Comply

7. The trade-off Introducing the Code of Best Practice: Eliminates the cost of the Moral Hazard problem through monitoring Decreases the flexibility at the manager’s decision level: the manager can not adapt his decision to market conditions ACLE- To Enforce and Comply

8. Aim of the paper • We analyze the adoption of Codes of Best Practice in environments where shareholders compete for managers, in order to study: • When firms choose to adopt a CBP • Whether this adoption depends on the structure of the market (characteristics of managers and shareholders), and how. ACLE- To Enforce and Comply

9. The Model • n risk neutral ShareholdersS = {s1, s2,..., sn} have access each to a project with whose value in case of success is R1 ≥ R2 ≥ ... ≥ Rn. • N risk neutral ManagersM = {m1, m2,..., mN} subject to limited liability. They are endowed with (possibly) different abilities: The cost for manager mj of exerting effort e is cj(e) = cje2/2, with 0 < c1 ≤ c2 ≤ ... ≤ cN. • A Firm (si, mj) is constituted when a manager-shareholder pair is formed (through a contract). Both shareholder and managers can seek for alternative partners (endogenous matching). ACLE- To Enforce and Comply

10. …the model… Once a firm (si, mj) is formed, the probability of success depends on two elements: • the efforte exerted by the manager • the market-specific conditionsh The parameter h • is random ex-ante • is known ex-post only by the manager • is distributed according to F(h), with mean a(h) and variance Var(h) ACLE- To Enforce and Comply

11. …the contract… • The contract includes the governance structure (CBP or Incentives) • A pair signs only feasible contracts, ACLE- To Enforce and Comply

12. Outcome and stability • An outcome for this market is a matching and a menu of contracts compatible with the matching • Besides, the outcome shall be stable (competitive equilibrium) ACLE- To Enforce and Comply

13. Contracts in a Stable Outcome Outcomes involve a matching between shareholders and managers and a contract that governs each firm. A first property of each of those contracts All the contracts in a stable outcome are Pareto optimal. ACLE- To Enforce and Comply

14. …optimal contracts… We can characterize any contract in a stable outcome as a function of the shareholder-manager pair (si, mj) and on the "minimum" utility Uj that has to be achieved by the manager. Two possibilities: ACLE- To Enforce and Comply

15. Contracts in a Stable Outcome A firm is more prone to adopt a CBP for: (1) environments with low variance, (2) low manager’s utility, (3) low effort’s cost, (4) better projects ACLE- To Enforce and Comply

16. We now discuss: • Two simple scenarios. • Whether good shareholders end up hiring high-quality managers. ACLE- To Enforce and Comply

17. Homogeneous Shareholders and Heterogeneous Managers • What are the characteristics of a stable outcome? Var(h) Low Variance High Variance ACLE- To Enforce and Comply

18. Note: High-ability managers are hired through Incentive contracts while a CBP is used to attract low-ability managers. This contrasts with the conclusion in the analysis of a single contract. When shareholders compete for the best managers, they offer a high utility level to high-ability managers and this makes Incentive contracts more appealing than contracts with CBPs. ACLE- To Enforce and Comply

19. Heterogeneous Shareholders and Homogeneous Managers • What are the characteristics of the stable outcome? Var(h) Low Variance High Variance ACLE- To Enforce and Comply

20. Heterogeneous Shareholders and Homogeneous Managers Ex-ante homogeneous managers end up with very different utilities Differences in the ex-post utilities due to: (1) shareholders’ heterogeneity and (2) the governance relationship (CBP or IC) ACLE- To Enforce and Comply

21. more about the matching A matching is positively assortative if shareholders with higher-revenue projects are matched with more efficient managers. Is the matching in a stable outcome always positively assortative? Often: If (m, W) is a stable outcome and in W they are all Incentive contracts, or they all include a CBP, then m is positively assortative. ACLE- To Enforce and Comply

22. …more about the matching… How does a non-possitively assortative matching in a stable outcome look like? if si = mj and si’ = mj’ with Ri > Ri’ and cj > cj’ then si and mj sign a contract including a CPB while si’ and mj’ sign an Incentive contract. In a non-possitively assortative matching in a stable outcome, shareholders with profitable projects hire low-ability managers through CBPs while high-ability managers sign Incentive contracts in less profitable firms. ACLE- To Enforce and Comply

23. …more about the matching… In our model, maximizing the total surplus requires a positively assortative matching. However,  the better the shareholder the more prone she is to adopt a CBP.  The better the manager, the more convenient is to use an Incentive Scheme In some cases, this trade-off leads to non-positively assortative matchings. ACLE- To Enforce and Comply

24. Conclusions • Under volatile environments (it is difficult to estimate market conditions), firms are not prone to adopt CBP • Environments with Heterogeneous shareholders and Homogeneous managers: - CBP is a mechanism used by the best shareholders to hire managers • Environments with Homogeneous Shareholders and Heterogeneous managers:- CBP is used to attract the worst managers • The coexistence of CBP and Incentive contracts may lead to negative assortative matchings ACLE- To Enforce and Comply

25. Some literature on CBPs • Empirical papers give mixed evidence: • Dahya et al. (JF 2002) • Fernández & Gómez (2002) Positive effect of the adoption of CBP for UK and Spain. • Nowak, Rott & Mahr (2004) • de Jong, DeJong, Mertens & Wasley (JCF 2005) No effect of the adoption for Germany and The Netherlands. • Theoretical paper: • Alonso-Paulí (2006) Studies the adoption decision and the design by a regulator. ACLE- To Enforce and Comply

26. Some literature on the framework • Assignment model: • Shapley & Shubik (IJGT 1972) • Roth & Sotomayor (1990) • Approach also adopted in: • Dam & Pérez-Castrillo (FET 2006) • Serfes (IJGT 2007) ACLE- To Enforce and Comply