Enjoying the quiet life: Corporate decision-making by entrenched managers

https://doi.org/10.1016/j.jjie.2017.12.003Get rights and content

Highlights

  • Cross-shareholdings of Japanese firms allow the managers to entrench themselves.

  • The managers avoid difficult decisions such as investments and restructurings.

  • The managers are likely to avoid taking risks for future growth.

  • Institutional investors and outside directors mitigate the problems.

  • Our results are consistent with quiet life hypothesis of the entrenched managers.

Abstract

In this study, we empirically test “quiet life hypothesis,” which predicts that managers who are subject to weak monitoring from the shareholders avoid making difficult decisions such as risky investment and business restructuring with Japanese firm data. We employ cross-shareholder and stable shareholder ownership as the proxy variables of the strength of a manager's defense against market disciplinary power. We examine the effect of the proxy variables on manager-enacted corporate behaviors and the results indicate that entrenched managers who are insulated from disciplinary power of stock market avoid making difficult decisions such as large investments and business restructures. However, when managers are closely monitored by institutional investors and independent directors, they tend to be active in making difficult decisions. Taken together, our results are consistent with managerial quiet life hypothesis.

Introduction

For decades, Japan has suffered from low corporate profitability, low economic growth, and poor stock market performance. Despite unprecedented and prolonged monetary policy meant to boost the economy, capital investments in the corporate sector have remained stagnant. Some have attributed the low profitability of Japanese firms to their failure to restructure and their aversion to risk (which, in turn, has suppressed innovation). The failure of firms to restructure and innovate may be related to the fact that managers’ interests may not always coincide with shareholders’ interests. That is, managers may make decisions to maximize their own utility rather than maximize shareholders’ wealth. For instance, managers may overinvest to grow a firm's size and increase their own private benefits. Given this problem, corporate governance may be useful for mitigating the conflict of the interest between managers and shareholders. To this end, some studies have suggested that corporate governance can assuage problems related to free cash flow/overinvestment (Jensen, 1986, Gompers et al., 2003, Harford, 1999). Interestingly, underinvestment on the part of managers has gone largely unexplored. This is likely because costs associated with under investment are relatively difficult to identify.1

Hicks (1935) argued that managers of monopolistic enterprises that are insulated from competition in the product market may not be motivated to adequately enact their managerial duties; shirking their responsibilities increases their own utility. Hicks (1935) dubbed this practice the “quiet life.” In other words, Hicks argued that when discipline from the product market is not sufficiently punitive, managers avoid difficult decisions and exert less effort. Hart (1983) also contended that discipline from the product market reduces managerial slack. Scharfstein (1988) and Schmidt (1997) came to similar conclusions.

This line of research was limited in its exclusive focus on discipline from the product market, but the quiet life hypothesis also includes discipline from the capital market (see Giroud and Mueller, 2010). This work shows that managers avoid making difficult decisions not only in companies protected from discipline from the product market, but also in companies that are protected from hostile takeovers or, more broadly, pressure from unfriendly shareholders. Bertrand and Mullainathan (2003) performed a critical study to empirically examine this extended version of the quiet life hypothesis. In this study, they focused on the introduction of state anti-takeover laws, which reduces the threat of a hostile takeover. More specifically, the authors used factory-level data in the US to evaluate how the introduction of state laws affects the corporate decision-making. Their results show that for companies with head offices located in the state where the anti-takeover legislation was passed, rates of factory construction and closure decreased, employees’ wages increased, and the firm's financial performance suffered. These results were not consistent with the free cash flow hypothesis, which predicts that managers seek to increase their own prestige by maximizing firm size rather than shareholder value.

The quiet life hypothesis essentially predicts that managers avoid making difficult decisions when they are protected from the disciplinary effects of the capital market. Because increasing investments (e.g., new facility development, acquisitions, R&D) requires substantial effort on the part of managers, managers may decrease these investments, even if they are expected to increase firm value. This forms the basis of the quiet life hypothesis—when insulated from disciplinary effects of the capital market, managers often underinvest. Because many managers of Japanese firms are protected from the disciplinary effects of the stock market through cross-shareholding, the quiet life problem is cause for some concern. Despite the importance of the quiet life problem, there has been no empirical study of underinvestment problem caused by Japanese firm managers who entrenched themselves.

It is also possible that the under-investment problem or failing to restructure their unprofitable businesses can be explained by the career concern hypothesis (see Holmström, 1999). The career concern hypothesis predicts that when managers face pressure from shareholders and have resultant concern for their own careers, they avoid risky investments that may fail due to exogenous shocks. Although it is rare for managers of Japanese firms to fail to get approval for their own director nomination proposals in shareholder meetings, the increasing influence of foreign institutional investors can raise these career-related concerns.2 Since friendly cross-shareholders reduce the career-related concerns held by managers, a higher ratio of these shareholders is likely to increase managers’ confidence in their job security, and will therefore lead to an increase in risky investments. So, by examining the effects of cross-shareholding on corporate behaviors, it is possible to simultaneously test these competing hypotheses.

In this study, we examine the effects of cross-shareholding and stable shareholding on corporate behaviors among companies listed on the Tokyo Stock Exchange from 2004 to 2014. Results of our analyses show that managers of companies characterized by a high proportion of cross-shareholding and/or stable shareholding avoid making difficult decisions or risky choices (e.g., large investments, restructuring). We also find that monitoring by institutional investors and independent directors mitigates these effects. Our results are consistent with quiet life hypothesis, but not with the career concern or free cash flow hypothesis. In addition, among the three shareholder categories, zaibatsu group firms, industry group firms, and lender banks, which mainly constitute cross-shareholding, none of one specific group dominates the observed negative effects on corporate investments and restructuring behavior. At most we can tell is that industry group shareholders tend to impede M&A and restructuring behavior of the firms.

To address the issues outlined above, we have organized this paper into a series of interrelated sections. In the following section, we discuss the relatively recent phenomenon of cross-shareholding in Japan. Then, in Section 3, we develop our hypotheses. In Section 4, we describe the data and methods we employ to test the hypotheses. We present the results of these analyses in Section 5. In Section 6, we report the results of robustness checks on our main results. In Section 7, we report relation between composition of cross-shareholders and corporate behavior, and we offer some concluding remarks in Section 8.

Section snippets

Cross-shareholding and stable shareholding

When there is little threat of hostile takeover or shareholder intervention, firm managers are free to make decisions that increase their own utility because they are unlikely to be replaced. Related to this, Bertrand and Mullainathan (2003) explored the effects of a state anti-takeover law in the American manufacturing industry from 1976 to 1995. They found that for companies with head offices in states where anti-takeover laws were passed, there were decreases in factory construction or

Hypotheses

When managers are not effectively monitored or subjected to discipline by shareholders, they may make sub-optimal decisions with respect to firm value. Moreover, managers who are entrenched in their positions, and are therefore shielded from takeovers or shareholder intervention, may overinvest as a function of a free cash flow problem (Gompers et al., 2003, Harford, 1999, Jensen, 1986) or underinvest due to a desire for a “quiet life” (Bertrand and Mullainathan, 2003). Although both

Data and sample

For the purposes of this paper, we constructed a panel dataset using data from non-financial companies that were listed on the Tokyo Stock Exchange.4 All financial data were obtained from the Nikkei NEEDS Financial Quest database. We obtained data related to the adoption of stock options, ownership structure, and outside director ratios from the Nikkei NEEDS-Cges Database. We

Empirical approach

To test the hypotheses developed in Section 3, we performed random-effects panel regression analyses. Similar to studies that have used corporate governance indexes as data, we did not use a firm fixed-effects model because cross-shareholding and stable shareholding did not change to a large extent over time. Inclusion of firm fixed effects would force the identification of the cross-shareholding coefficient from only small changes.7 Therefore, we

Propensity score matching test and 2SLS test

Although the results presented above are consistent with H1 and H2, because our results depend on the linear regression models, there is a potential misspecification problem. In addition, we did not include a firm fixed effect in the regression models, it is still possible that our presented results are driven by unobservable time invariant factors that correlate with cross shareholding. It is possible that better-performing firms had already resolved any problems related to interlocking

Cross-shareholder composition and firm behavior

The above results show that when the cross-shareholding ratio of a firm is high, the management tends to avoid difficult decisions and enjoys quiet life. Here, one aspect we should pay attention to is that unlike institutional shareholding, cross-shareholding and stable shareholding do not point to a specific shareholder category. They can be broadly divided into three shareholder groups. The first group includes companies which are members of a zaibatsu, a Japanese conglomerate corporate group

Conclusion

In this paper, we have empirically examined the effects of cross-shareholding and stable shareholding on corporate behaviors. Our results are consistent with the quiet life hypothesis (Bertrand and Mullainathan, 2003), which claims that managers who are protected from the disciplinary effects of the capital market avoid making difficult business decisions and exert less effort in the performance of their duties. Although cross-shareholding in Japan decreased between 1997 and 2004, contemporary

Acknowledgments

We would like to thank Shin-ichi Fukuda, Masaharu Hanazaki, Takeo Hoshi, Takatoshi Ito, Alexander Ljungqvist, Hideaki Miyajima, Masao Nakamura, Kazunori Suzuki, Konari Uchida, Yupana Wiwattanakantang and participants at the 2016 Nippon Finance Association Conference and the 26th NBER-TCER-CEPR Conference. All of these individuals provided valuable comments and suggestions. This work was supported by JSPS KAKENHI Grant No. 15H03375.

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