Charles R. Knoeber

Firm Performance and Mechanisms to Control Agency Problems between Managers and Shareholders

This paper examines the use of seven mechanisms to control agency problems between managers and shareholders. These mechanisms are: shareholdings of insiders, institutions, and large blockholders; use of outside directors; debt policy; the managerial labor market; and the market for corporate control. We present direct empirical evidence of interdependence among these mechanisms in a large sample of firms. This finding suggests that crosssectional OLS regressions of firm performance on single mechanisms may be misleading. Indeed, we find relationships between firm performance and four of the mechanisms when each is included in a separate OLS regression. These are insider shareholdings, outside directors, debt, and corporate control activity. Importantly, the effect of insider shareholdings disappears when all of the mechanisms are included in a single OLS regression, and the effects of debt and corporate control activity also disappear when estimations are made in a simultaneous systems framework. Together, these findings are consistent with optimal use of each control mechanism except outside directors.

Testing the Theory of Tournaments: An Empirical Analysis of Broiler Production

Broiler chickens are raised by contract growers whose rewards depend explicitly upon relative performance. We use data on the performance of broiler producers facing both tournament and linear performance evaluation compensation structures to test three predictions from the theory of tournaments: that changes in the level of prizes that leave prize differentials unchanged will not affect performance; that, in mixed tournaments, more able players will choose less risky strategies; and that tournament organizers will attempt to handicap players of unequal ability or reduce mixing to avoid the disincentive effects of mixed tournaments. Our evidence is consistent with each prediction.

Don't Count Your Chickens...: Risk and Risk Shifting in the Broiler Industry

The contracts used to reward growers of broiler chickens in the United States base pay on a growers performance relative to other growers. From a panel of data covering seventy-five growers over four years, we use simulation methods to measure the price and production risk shifted from growers to integrator companies by these contracts. We also decompose the risk in broiler production variability. We conclude that the bulk of the risk in our sample, which is primarily price risk, is shifted from growers through the use of production contracts.

Understanding Retained Patronage Refunds in Agricultural Cooperatives

The share of patronage refunds retained by an agricultural cooperative is modeled as arising from the portfolio decision of its median member. The member is viewed as maximizing expected utility by allocating wealth between investments in farming assets and equity in the cooperative. Determinants of the share of patronage refunds retained are the expected rates of return on these two investments, their variances, their covariance, and the expected future share of patronage and its variance. Empirical examinations of aggregate cooperative data and cross-section analysis of seventeen regional supply cooperatives are found to be consistent with the model.

Outside Directors, Politics, and Firm Performance

A substantial number of outside directors have experience in non-business arenas, especially in government and in the private practice of law. Moreover, for most of these directors, the entirety of their experience is outside of business. We propose a political role for such directors and argue that they are selected, at least in part, because of their value in enlisting government favors or forestalling government constraints. To assess this possibility, we analyze the backgrounds of the 3,220 directors of 264 large U.S. manufacturing firms. We also compile a novel dataset that contains detailed measures of the importance of politics to firms. We have three main findings. First, we find that outside directors with political and legal backgrounds appear to be chosen, at least in part, because of this experience. Second, we find that such directors are more common on the boards of firms for which politics is more important. Both findings are consistent with a political role for these outside directors. Third, we explore the possibility that recent findings showing a negative relation between firm performance and both board size and the proportion of outside directors could be driven by politics. Specifically, politics may lead simultaneously to larger and more outsider oriented boards and to poorer firm performance. We assess this possibility by including, first, the incidence of directors with political or legal backgrounds and, second, our measures of the importance of politics in regressions that find this negative effect of board size and composition on firm performance. Although our results are modest, the added political variables are typically negatively related to firm performance and the addition of these variables weakens the effect of both board size and board composition on firm performance. This is evidence consistent with politics underlying the negative relation between board size and composition and firm performance. Overall, this paper provides empirical evidence on an important, but neglected, role of corporate boards and provides a rational explanation of the otherwise puzzling negative relation between firm performance and both board size and the proportion of outside directors.

Contests to Become CEO

Firms tend to promote insiders to the CEO position rather than to hire outsiders. This paper explains this phenomenon by developing a framework in which firms value the incentive that the contest to become CEO provides to current employees, but also want the most able candidate (insider or outsider) to become CEO. We determine the optimal payment to current employees, the payment to the new CEO if she is promoted from within, the payment to the new CEO if he is hired from outside, and the size of the handicap imposed on outside candidates (i.e., the bias toward insiders). We find that, at the optimum, outsiders must be clearly superior for the firm to facilitate their selection via negative handicapping (i.e., a bias towards outsiders). By contrast, if outsiders are not clearly superior, incentive provision to insiders via handicapping of outsiders or via higher payments to successful insiders is more important than selecting the most able CEO. We also find that the ability (or inability) of a firm to precommit to a large payment to a promoted insider CEO is critical. The ability to precommit reduces the handicap imposed on outsiders, raises the payment to insider CEOs, and lowers the payment to current employees. The outsider handicap, and so the likelihood that an insider will be chosen, depends positively on the number of insiders and the number of outsiders competing to be CEO, provided that the firm cannot precommit. The handicap imposed on outsiders can depend positively on the extent of commonality among insiders, provided that the firm wants to elicit effort from insiders but this effort is relatively small. The handicap depends negatively on the average ability of outsiders, the extent of commonality among insiders (provided that the firm wants to elicit effort from insiders and this effort is relatively large), the similarity of the shocks faced by insiders and outsiders, and financial stress faced by the firm.

Why do corporations contribute to the Nature Conservancy

Treating corporate contributions as purchases of valuable inputs, we hypothesize that firms for which genetic diversity, advertizing, and reputations of environmental responsibility are more valuable and firms for which the cost of contributing is less will be more likely contributors to the Nature Conservancy. These hypotheses are supported by logit estimations which find firms in industries where biological inputs are important, firms with high advertizing expenditures, firms in industries with high costs of meeting environmental regulations, and large firms are more likely to contribute and so become Corporate Associates of the Nature Conservancy.

The Effect of Tougher Enforcement on Foreign Firms: Evidence from the Adelphia Perp Walk

The public arrest of Adelphia executives John Rigas and his two sons on July 24, 2002 and the spectacle of these executives being paraded in front of news reporters and photographers signaled tougher enforcement of laws against corporate crime. Relative to domestic firms, foreign firms traded in the U.S. fared badly on the day of the Adelphia perp walk, underperforming by 1.8% (by 2.5% when controlling for industry and the financial characteristics of firms). A framework based on the expected cost to firms from tougher enforcement suggests three possible reasons. Foreign firms may be targeted more heavily, may face greater reputational penalties, or may find it more costly to react to (deflect) enforcement. We construct variables linked to each reason and test to see if these explain the July 24 returns of foreign firms. We find some evidence consistent with each of the suggested reasons, but stronger evidence for differential targeting and higher reaction costs for foreign firms.The public arrest of Adelphia executives on July 24, 2002 signaled tougher enforcement of laws against corporate crime. On that day and the two following days, foreign firms experienced a cumulative 1.7% decline in value. Relative to domestic firms, the loss was a much larger 4.5%. The expected cost to firms from tougher enforcement suggests three possible reasons. Foreign firms may be targeted more heavily, may face greater penalties, or may find it more costly to react to (deflect) enforcement. We find evidence consistent with foreign firms facing higher costs from tougher enforcement for each of these reasons.

Improving the behavior of public officials: Changing the method of compensation and changing officials

ConclusionOthers have offered a variety of suggestions to improve the behavior of public officials. Each of these involves linking an officials (public) compensation to a measure of his performance. This is costly because performance will necessarily be imperfectly monitored and so public officials will be forced to bear risk. An alternative suggested here is to select the ‘right’ individuals for public office, those whose private interests are linked to the productivity of public officials.The case of a school board member is developed. First, an incentive contract (compensation for effort) for the board member is defined and his behavior characterized. Next the optimal reward for effort is derived. It is then shown that a board member will be more productive (holding constant his public compensation) if he places a high value on better schools and owns property within the school district. If the alternative of choosing the ‘right’ officials is employed to improve performance, actual school board members should have these characteristics. A survey of school board members in Texas indicates not only that board members tend to have these characteristics, but that they believe them to be necessary qualifications for the office.