Lalitha Naveen

Boards: Does One Size Fit All?

This paper reexamines the relation between firm value and board structure. We find that complex firms, which have greater advising requirements than simple firms, have larger boards with more outside directors. The relation between Tobin’s Q and board size is U-shaped, which, at face value, suggests that either very small or very large boards are optimal. This relation, however, arises from differences between complex and simple firms. Tobin’s Q increases (decreases) in board size for complex (simple) firms, and this relation is driven by the number of outside directors. We find some evidence that R&D-intensive firms, for which the firm-specific knowledge of insiders is relatively important, have a higher fraction of insiders on the board and that, for these firms, Q increases with the fraction of insiders on the board. Our findings challenge the notion that restrictions on board size and management representation on the board necessarily enhance firm value. r 2007 Published by Elsevier B.V. JEL classification: G32; G34; K22

Co-opted Boards

We develop two measures of board composition to investigate whether directors appointed by the CEO have allegiance to the CEO and decrease their monitoring. Co-option is the fraction of the board comprised of directors appointed after the CEO assumed office. As Co-option increases, board monitoring decreases: turnover-performance sensitivity diminishes, pay increases (without commensurate increase in pay-performance sensitivity), and investment increases. Non-Co-opted Independence—the fraction of directors who are independent and were appointed before the CEO—has more explanatory power for monitoring effectiveness than the conventional measure of board independence. Our results suggest that not all independent directors are effective monitors.

Organizational Complexity and Succession Planning

This study uses a large sample of firms to examine how human capital considerations affect the process of CEO succession. Costs and benefits of succession planning are affected by a firms level of operational complexity and human capital requirements; firms that are more complex incur greater costs to transferring firm-specific knowledge and expertise to an outsider, and should be more likely to groom an internal candidate for the CEO position. Consistent with this, I find that a firms propensity to groom an internal candidate for the CEO position is related to firm size, degree of diversification, and industry structure. My results also suggest that succession planning is associated with a higher probability of inside succession and voluntary succession and a lower probability of forced succession. I also provide evidence that horizon problems are mitigated to some extent by having a succession plan.

The Hidden Cost of Managerial Incentives: Evidence from the Bond and Stock Markets

We examine how incentives embedded in managerial compensation contracts are priced by the bond and stock markets. Specifically, the incentives we consider are the sensitivity of CEO wealth to stock price (delta) and the sensitivity of CEO wealth to stock-return volatility (vega). Controlling for other determinants, we find that higher levels of both vega and delta are associated with higher bond credit spreads and higher expected stock returns. In addition to having a direct effect on credit spreads and expected stock returns, higher incentives are also associated with lower average cash flows, higher volatility of cash flows, and higher volatility of stock returns (all of which increase credit spreads), and higher systematic risk (which increases expected stock return). Thus, higher incentives have a cascading effect on credit spreads and expected stock returns. Also, a portfolio of high-incentive firms significantly underperforms a portfolio of low-incentive firms on a risk-adjusted basis; thus, on average shareholders appear to be harmed ex post as a result of incentive provision.

The Advisory Role of Foreign Directors in U.S. Firms

We study the role of foreign directors in U.S. firms. We conclude that foreign directors, especially those from countries that are dissimilar to the U.S. in terms of business environment (i.e., dissimilar directors), are chosen by multinational corporations (MNCs) to provide advice, and this advice is valuable. We measure director dissimilarity along the dimensions of legal regime, language, trust, and religion. Our conclusion is supported by two findings. (i) Firms with operations in countries that are dissimilar to the U.S. in terms of business environment are more likely to choose dissimilar directors. (ii) The average announcement period return to the appointment of foreign directors is significantly positive, and is due to appointments by MNCs, and within MNCs, to dissimilar directors. Analysis using Tobin’s q leads to similar inferences.

Dividends, Investment, and Financial Flexibility

Faced with cash flows that fall short of the sum of expected dividend and investment levels, firms must do one of the following: cut dividends, cut investment, or raise funds through security sales, asset sales or reductions in cash reserves. Our analysis indicates that while very few firms (6%) cut dividends, the majority (68%) make significant cuts in investment relative to expected levels. Investment cuts make up for approximately half of the shortfall, with the other half being covered primarily by debt financing. Net equity issues, reductions in cash balances and asset sales account for a trivial percentage of the shortfall. Our findings challenge several widely-held views in the corporate finance literature.

Costs of Performance Pricing Loans

We examine how monitoring costs and costs of financial distress affect the use of performance pricing provisions in bank loan contracts. We find that firms that are easier to monitor, such as those with better accounting quality, lower information opacity, or a stronger prior relationship with the lender are more likely to have performance pricing loans. The likelihood of using performance pricing is significantly reduced after financial restatement events. Conditional on using performance pricing loans, firms with lower (higher) accounting quality are more likely to have credit rating (accounting) based performance pricing loans. Finally, we find that the use of performance pricing decreases in the likelihood of financial distress. Our results are robust to various alternative measures of accounting quality, information opacity, as well as default risk. Our results are consistent with the notion that the quality of accounting information has a significant influence on the design of financial contracts.

Asymmetry in Pay for Luck: A Size Effect?

Garvey and Milbourn (2006) document an asymmetry in pay for luck. Their methodology involves decomposing stock returns into luck and skill. Theoretically, the estimates of luck and skill should have zero correlation; empirically, the correlation is –44%. We find that this correlation arises due to lack of control for firm size. We find no asymmetry once we control for size. Specifically, we find no asymmetry (i) if we exclude the largest 0.4% of firms; (ii) using estimates of luck and skill from return-decomposition models that account for size; and (iii) using estimates of luck and skill where correlation is zero.

Co-opted Boards: Causes and Consequences

We develop a measure of board co-option - the proportion of directors who joined the board after the CEO assumed office - and analyze whether this measure captures the extent to which the CEO can exert control over the board. We find that the sensitivity of CEO turnover to performance decreases in board co-option. CEO pay and pay hikes increase with co-option but there is no offsetting increase in pay-performance sensitivity. On the other hand, R&D intensity increases in co-option. Observed co-option increases in the importance of firm-specific human capital and measures of CEO power. Finally, Tobins q increases in co-option for firms that benefit from CEO investment in firm-specific human capital while for other firms there is no relation between q and co-option. All results are robust to controlling for the proportion of independent directors on the board, CEO tenure, and alternative measures of co-option. We conclude that independent directors who join the board after the CEO assumes office are at least partially aligned with the CEO. In contrast, independent directors who joined before the CEO appear effective at monitoring the CEO.