When to fire bad managers: the role of collusion between management and board of directors
Introduction
Even among capitalist economies, there are pronounced differences in the way corporations are run. In the US and the UK, for example, most of the large firms are supervised by a Board of Directors (BoD). The BoD is composed of outside directors as well as executive directors, who are involved in the day-to-day management of the firm. The ultimate power, however, rests with the shareholders, who always have the possibility to fire the management. The Anglo-Saxon system is therefore often cited as an example of how corporate governance should be organised in countries where shareholders have much less influence on the way the company is run.
In Germany and the Netherlands, it is common to have a separation between the management and the BoD. In such a two-tier system, the BoD often acts as an autonomous body which is beyond the control of the shareholders.1 It is frequently argued that this lack of shareholder power gives rise to situations in which the management and the BoD mutually protect each other at the expense of the shareholder.2 In this paper, however, we argue that such collusion between management and directors is not always bad for the shareholders.
To show why this may be the case, we consider a simple two-period model of a firm which hires a manager at the start of the first period. The match between the manager and the firm may turn out to be either good or bad. The quality of the match is beyond the control of the manager or the firm: it is merely a ‘move by Nature’. If the match is bad, the shareholder would like to fire the manager at the end of the first period.3
At that moment, the manager learns about the size of a personal cost that he will incur in the event of being fired. In practice, the firing cost can take several forms. For example, it may capture foregone income as well as the loss of resources in the process of searching for a new job and moving to another place. But there may also be other, less tangible costs, such as the loss of reputation and valuable contacts. It is reasonable to assume that these costs are, at least partly, unknown ex ante, for example because it is not clear what the manager’s job market position or legal position will be in the future. However, for the manager to be willing to run the firm, he needs to be ex ante compensated for his expected firing cost.
In the ideal situation, the shareholder would observe this firing cost also and be able to commit ex ante to not firing the manager in those cases in which his firing cost exceeds the expected gain from hiring a new manager. Rather realistically, we assume that the shareholder can only learn about the quality of the match through the observation of the firm’s first-period cash-flow. Moreover, the shareholder does not observe the realisation of the firing cost. Therefore, the shareholder may want to delegate the power whether or not to fire the manager to a director who monitors the company more closely and thus can make better informed decisions. If the firing cost of a (bad) manager turns out to be relatively high, he has the incentive to bribe the director not to fire him. The possibility of such collusion may be in the interest of the shareholder, because it saves him the resources needed to compensate the manager it ex ante for potentially high realisations of the firing cost. Thus, collusion avoids part of the deadweight losses associated with firing decisions.
The model is primarily meant to analyse a two-tier corporate governance system, in which the BoD (the Supervisory Board) is independent of the management and thus has the power to fire the management. It could also apply to a one-tier system if the Board includes a number of outside (non-executive) directors, who perform a monitoring role similar to the one carried out by the BoD in the two-tier system. In that case, the outside directors might be bribed by the executive directors to induce them to fulfil their monitoring role less zealously. However, a crucial assumption for the results to hold is that the BoD be independent of the shareholders. If not, as is usually the case in the one-tier system, the way it is applied in the US and the UK, the possible collusion mechanism would break down. The reason is that the shareholders can always get rid of a bad manager, no matter how large his personal firing cost is. In the two-tier system, a breakdown of the mechanism is likely if large shareholders are represented on the Board. The size of the bribe needed to compensate such Board members for the expected loss from retaining a bad manager may well be too large for him to pay. In the model, we assume that the Board is independent, and hence, that large shareholders are not on the Board.
For simplicity, the model assumes that collusion between the manager and the director takes place through a monetary transfer from the former to the latter. In reality, however, such a bribe would often be less tangible. For example, in a corporate system with interlocking directorships and strong informal ties across firms the manager might recommend the director at other firms for a directorship. Another example would be a tightening of buyer–seller relations between the manager’s firm and firms in which the director has a stake or of which he is manager himself.
To focus on the question under what circumstances collusion can be beneficial, we keep the model as simple as possible by ignoring the effect that manager effort can have on the firm’s performance. However, there is large principal-agent literature that focuses on designing compensation schemes that a shareholder can use to extract the optimal level of effort from a manager.4 This standard model has been extended to incorporate a supervisor as another layer between the principal and the agent (e.g. Baron and Besanko, 1984). According to Kofman and Lawarree (1993), however, ‘the research in this area has by and large neglected the possibility of collusion.’
An important exception is Tirole (1986), who adds a set of ‘coalition incentive compatibility constraints’ to the usual individual rationality and incentive compatibility constraints, such that the final allocation is coalition-proof. Kofman and Lawarree (1996) develop a model in which it may be optimal for the principal to allow for collusion. However, this result is obtained because deterring collusion is costly in their model. In contrast, in our model, even if it is costless to prevent collusion, allowing for collusion between management and director can be beneficial to the principal.
Our argument is developed in the following steps. Section 2 presents the basic model. In Section 3, we study from the shareholder’s point of view the ideal benchmark case where the shareholder after one period observes the manager’s type and his firing cost, and from the start can commit to a firing rule based on the realisation of the firing costs. Section 4 relaxes these assumptions in the sense that the shareholder only receives only a noisy signal in the form of a realisation of the firm’s cash-flow, on which he bases the firing decision.
The next step (Section 5) then is to delegate the firing decision to a director, who has an information advantage because he monitors the manager more closely. The salary of the director depends on the cash-flow of the firm. The manager receives a fixed salary as well as a fixed severance payment which is paid only when he is fired. As a higher severance payment reduces the incentive of a bad manager to bribe the director, the shareholder would want to set it as high as possible if collusion is undesirable. However, in those cases in which it is desirable to allow for collusion, the severance payment will help to ensure that firing takes place only when the realised firing cost is relatively low.
Section 6 explores under what conditions the shareholder would allow for the possibility of collusion, even if he were able to prevent it without any cost. This bears upon the debate whether the shareholder position in Germany and the Netherlands should be strengthened, or more specifically, whether regulators or corporate law should give shareholders more instruments to prevent collusion if they wish to do so (for example, stricter information disclosure rules, more powers to fire managers or directors). Section 7 concludes the paper.
Section snippets
The basic model
We consider a two-period model without discounting and in which all agents are risk-neutral. Qualitatively speaking, the assumption of risk neutrality does not affect our results. A firm is owned by a shareholder5, who randomly selects a manager at the start of the first period. The cash-flow generated by the firm in any given period depends on how
The first best
The shareholder’s payoff is maximised if he can observe perfectly both the type of the manager and his firing cost at the end of the first period, and if he can commit ex ante (i.e., at the start of the first period when contracts are signed) to a firing rule which depends on the realised firing cost. The resulting solution will be termed the first best.
No director
From now on, we assume that the shareholder observes neither the type of the manager nor his firing cost at the end of the first period.9 Therefore, the only information upon which the shareholder can base his
Introducing a director
From now on, the shareholder can delegate the firing decision to an independent director. The director may be expected to have more information about the manager than the shareholder. According to Fama (1980), the director can be viewed as a market-induced institution, ‘[…] whose most important role is to scrutinize the highest decision makers in the firm.’ In particular, we assume that, while the shareholder is not able to observe the manager’s type, the director can observe his type perfectly
When is it optimal to allow for the possibility of collusion?
While the previous section analysed under what conditions collusion between manager and director actually occurs when collusion is allowed, in this section, we explore whether the shareholder would want to make use of the possibility to prevent collusion, if he could do so without any cost. To be precise, ‘preventing collusion’ means that collusion never occurs, while ‘allowing for collusion’ means that collusion may or may not occur, depending on the realisation of the firing cost. The
Concluding remarks
In this paper, we have argued that collusion between the BoD and the management of a firm is not always bad for the shareholders of the firm. In particular, collusion alleviates the costs associated with the failure to commit to not firing a bad manager if his personal firing cost is relatively high. The possibility of collusion reduces the compensation required by the manager.
In order for the intuition behind our results to be as clear as possible, we have deliberately kept the model simple.
Acknowledgements
We thank, without implicating, Marco Haan, for detailed comments on an earlier version of this paper. We also thank seminar participants at Groningen University, Maastricht University and the University of Namur for their helpful comments. The usual disclaimer applies. Rebers gratefully acknowledges financial support from the ESR (grant no. 510-31-103). Beetsma thanks NWO for financial support (grant no. 400-70-015/11-3).
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