Monitoring and Collusion in the Family Firm Part 1

Monitoring and Collusion in the Family Firm Submitted to the Department of Economics in partial fulfillment of the requirements for the degree ofBachelor of Arts with Honors i Contents 1. Introduction..................................................................................................................... 2 2. Literature Review............................................................................................................ 4 3. Theory and Background.................................................................................................. 8 3.1 The Principal-Agent Problem ................................................................................... 8 3.2 Controlling Minority Shareholder Structures ........................................................... 9 3.3 The Board of Directors ........................................................................................... 11 3.4 Disciplining the large shareholder: Proxy fights and Takeovers............................ 13 3.5 Collective action ..................................................................................................... 15 4. Model ............................................................................................................................ 16 4.1 Manager-CEO Collusion and Proxy Fights ............................................................ 16 4.2 Takeovers and Family Management....................................................................... 26 5. Applied Analysis........................................................................................................... 27 5.1 The New York Times Company............................................................................. 27 6.2 Dillard’s .................................................................................................................. 32 5.3 Dow Jones & Co ..................................................................................................... 34 5.4 Ford Motor Company ............................................................................................. 36 6. Conclusion .................................................................................................................... 38 1 1. Introduction More than 80% of the US workforce is employed by a family business (Miller, Steier, & Le Breton-Miller, 2003). These include not only small businesses, but some of the largest, most well-known publicly traded companies in the country such as Wal-Mart, Comcast, Ford, and Motorola. Family ownership in these companies varies from 10% to 40%, but the family’s power may be disproportionately greater due to voting systems designed so that family members have a greater say in the decision-making process of the firm. The reasons for having a family business in a developing country seem fairly clear—in places with weak contract enforcement and a poor legal system, hiring family members is far less risky than hiring strangers. Furthermore, if it is difficult to borrow money, going into business with the extended family may provide a way to share risk and borrow necessary start-up capital. Besides, in many countries, being part of a prominent business family may get you influential connections in politics, which can further entrench your family in the elite. The benefits of family firms are far less clear in large American firms. Flipping through The Family Business Review will immediately show you several drawbacks. Nepotism or the expectation of nepotism can keep the most talented workers and managers away from family firms. Personal animosities between family members can tear the business apart. Families can insist on keeping and controlling the business even when it would be in everyone’s interest to sell it. Is family ownership simply an outdated relic of pre-industrial times? 2 Three benefits remain in family-owned businesses. First, the close relationship between family members may make it easier to enforce the behavior of other family members who are hired by the company. Second, the family retains any perks that may come from owning and controlling the company. And lastly, family members may acquire firm-specific and industry-related human capital by growing up in the firm, so hiring family members may benefit the firm. My paper seeks to use the first two of these benefits, easier enforcement and private benefits, to explain a finding from Anderson and Reeb’s 2004 article “Board Composition: Balancing Family Influence in S&P 500 Firms.” In this study, they find that family firms are the most productive of S&P 500 firms. However, within family firms, performance varies depending on board composition. At low levels of family board representation relative to independent director representation, adding more family directors improves performance, but when the ratio of family to independents is more than 1:2, performance deteriorates with more family members on the board, perhaps due to conflicts of interests with outside shareholders. The board appears to mitigate conflicts of interest between shareholders as well as monitoring the managers; the authors suggest that “founding families monitor the firm, while independent directors monitor the family.” I hope to formalize this intuition by showing how the family’s superior ability to monitor the CEO and their ability to collude with him at the expense of outside shareholders makes their presence on the board both potentially helpful and potentially detrimental to outsiders. I also go beyond Anderson and Reeb’s finding to look at how outside shareholders may try to curb family-CEO collusion by putting more independents on the board or by taking over the company. 3 The rest of the paper is structured as follows: Section 2 reviews the literature on family firms and on corporate governance. Section 3 provides some background on the relationships between the family, the outside shareholders, the CEO, and the board of a family-owned corporation. Section 4 introduces my model. Section 5 attempts to apply this model to a few recent cases: Dillard’s and The New York Times Company, which have recently been threatened with proxy fights, and Dow Jones and Co. and Ford Motor Company, where the controlling family has been in danger of losing ownership. Section 6 concludes. 2. Literature Review There has been a recent surge of research on family firms, based on the understanding that the relationship between the owning family and business partners produces unique governance problems. My thesis ties together this research with a strand of research dedicated to explaining monitoring and collusion in firms with large shareholders. The family here is not only the largest shareholder but has a unique incentive to choose a CEO from within the family, both to ease monitoring and to extract private benefits more easily. Family businesses are ubiquitous but hard to define. In the United States, they are often defined as firms that are owned and controlled by several members of the same family, usually the descendents of the company’s founder. However, researchers differ over whether the definition should include businesses where the founder and no other individual has most of the influence over the firm or firms that are owned but not 4 managed by a family. In this paper I view the family firm as a firm where one family holds the largest single ownership block, though they may choose to hold management positions as well. Business research on family firms tends to emphasize the necessity of organizing the family and putting in mechanisms to limit infighting and discord. It often considers the interrelationships between members of the family firm and how these can be arranged to minimize conflict and inefficiency. The family business often does not last because the founder’s personality leaves its imprint on the firm long after he has retired. The founder’s strategies influence the successors’, especially if the successor happens to be a close relative. In that case, the successor may either be too reluctant to change what his predecessor has put into place or too eager to completely redefine the company’s mission (Miller et al., 2003, p. 514). Economics papers have focused on different facets of family ownership and how they affect firm performance. Some papers model the difference in family firms as one of different human capital. Special business skills are passed down in the family as the younger generation gains work experience in the family firm. Bhattacharya and Ravikumar (2001) model the family as having no other private benefits of control, so that they choose to bequeath wealth either through the business or by selling the business and passing on the proceeds, whichever yields more utility. Another set of papers looks at the family’s possible expropriation of firm profits, which depends on how well laws can protect the smaller shareholders’ rights. More legal protection for minority shareholders increases the likelihood of firm management being separated from ownership. If there is very good legal protection, then the founder does 5 not have to monitor the manager in order to prevent him from stealing the firm’s profits. On the other hand, if legal protection is very bad, then management is kept in the family. At intermediate levels of legal protection, the firm is best off hiring a professional manager, if they are more qualified than a family member, but the family should monitor (Burkart, Panunzi, & Shleifer, 2003, p. 2170). Schulze et al. propose that altruism among family members leads to unique problems when families both own and work in the firm. Family members employed by the company, knowing that an altruistic relative is unlikely to fire them, do not work as hard. Nepotism is inefficient, both because more competent outsiders cannot easily join the family business and because family members may be stuck in the family business instead of careers that better suit them (Stewart, 2003, p. 386). However, hiring family members has its benefits as well. Managers chosen from within the controlling family have similar interests regarding risk and growth opportunities, where an outside manager may have other interests that lead him to make decisions that do not fit in the family’s vision. Families can also monitor their relatives more easily and discipline them outside of the business relationship (Schulze, Lubatkin, Dino, & Buchholtz, 2001). Another approach sees the family firm not as the victim of special moral hazard problems but as the beneficiary of a long-term approach to the business. This so-called stewardship theory predicts that family members, unlike hired workers and managers at other firms, have a long-term interest in seeing the company succeed so that it can be passed down to their children. Unique among other shareholders, they cannot easily shift their money to another company because they are loyal to their own. Instead, loyal family members will keep their money in the firm but demand changes that will help the firm 6 become profitable again. This loyalty keeps the firm keep going when other owners would have sold it (Hirschman, 1970, p. 77). A spokesman for Ford Motor Company, for instance, credits the family’s backing for keeping the company in business during World War II and the recession in the 1980s (Lippert & Koenig, 2007). My thesis is also related to a strand of corporate governance literature that deals with the monitoring of managers and possibilities for collusion between large shareholders and the manager. This is also a growing area of research, especially following the scandals at Enron and other large companies in 2002. In “A Survey of Corporate Governance,” Shleifer and Vishny define corporate governance as “the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment.” (1997, p. 737). The problem is, at its heart, that the legal owners of firms, the shareholders, delegate responsibility to professional managers, who may not be as interested in merely receiving a high return on the investment. In the Jensen-Meckling theory of the firm, reducing the manager’s ownership in the firm increases the likelihood that he will consume private benefits that accrue only to the manager, since he receives all of these but only a fraction of the firm’s income (Block & Jaskiewicz, 2007; Jensen & Meckling, 1976). However, the separation of ownership and control has its benefits as well. When ownership is widely dispersed, managers have more discretion, so they can make profitable investments that a controlling owner would perhaps not have made because they were too risky (Burkart, Gromb, & Panunzi, 1997). Harvey James suggests that family firms do not face the usual problems that result from the separation of ownership and control. The long horizon of family firms may make it in the family’s 7 interest to invest, while still limiting the agency costs that plague companies with dispersed ownership (1999). 3. Theory and Background 3.1 The Principal-Agent Problem A classic problem in economics concerns the relationship between a principal, often the owner of a firm, and an agent. The principal hires the agent to perform a task, but the principal and the agent have different objectives. The agent also has relevant information available only to him, so that the principal cannot make a contract that provides incentives for the agent to perform exactly as he wishes. The agent may be able to take an action that the principal cannot directly observe, such as exerting little effort (moral hazard), or may be hired without revealing some information about himself, such as his competence level (asymmetric information). A firm contains several principalagent relationships, between owners and managers, managers and workers, and so forth. This paper focuses on the incentive problem that arises between the owners of a large public firm and the CEO whom they hire to make most of the day-to-day decisions. Professional managers are more skilled at running the firm than the owners are, but they may exert less effort than the owner would like or put their effort into actions that do not increase shareholder value. There are several mechanisms to reduce these agency conflicts. Increasing the manager’s ownership share of the firm helps align his interest with that of the firm’s 8 owners. Incurring debt could also put more pressure on the manager. If the company goes bankrupt, he loses his control and his reputation suffers (Bathala & Rao, 1995, p. 62). One of the most important controls on the CEO is the board of directors, which has the authority to fire the top management and authorize major decisions. Even with these enforcement devices, the principal-agent model may be too simple to adequately explain behavior within a firm because it does not take into account the other possibilities that come into play as more people are put into contact. Tirole’s “Hierarchies and Bureaucracies” enriches the principal-agent model by adding another agent between the principal and the agent: the supervisor. The supervisor’s role is to monitor the agent and report back to the principal. However, the agent and the supervisor can form a coalition: the supervisor can choose to not pass on certain information to the principal if the agent gives him a side payment. (Tirole, 1986, 2005, pp. 362-364). This is the framework on which I base my model. Like the supervisor in Tirole’s model, the board of directors can monitor the actions a manager (the company’s CEO) takes. However, in family-controlled corporations, the family sits on the board and supervises the manager. This gives them the power to collude with the manager at the expense of the other shareholders. 3.2 Controlling Minority Shareholder Structures Family firms face problems due to there being a close group of large shareholders: the family. Large shareholders present a particular challenge in corporate governance because individual minority shareholders rarely have stakes large enough to make it worth the cost of carefully following the company and airing their grievances. The large 9 shareholder is then the one mostly in charge of monitoring the manager. In such cases, the large shareholder may collude with the management in a way that enhances some private benefits that they receive at the expense of shareholder value. The shareholders do have some power, in that they can sell their shares in the company. However, they have no other methods of controlling management that do not cost more than their small stakes would make worthwhile. The private benefits that the large shareholder can receive include special perks taken out of firm value, such as company jets or fancy dinners, as well as the ability to make deals with other firms that the large shareholder may have investments in, even though these deals may not be optimal for the original firm. In some firms, the large shareholder dilemma is magnified by arrangements that ensure that a certain group retains rights to control the company that are out of proportion with their voting rights. One common mechanism is dual-class shares, where the founder or his family commonly holds Class B stocks with more voting power than the common Class A stocks that are sold on the markets. Such structures are common in the United States as well as abroad. Many times the founders of companies create such structures to ensure that their family has control over the company even as it grows to the point where most of the investment capital comes from outside. This is sometimes done to maintain the integrity of the firm’s mission: the New York Times Company, for example, insists that the Ochs-Sulzberger family’s control of the company lets them keep up a standard of journalistic integrity. Google is also run with a dual-class structure that lets the founders exert control over what it does. Financial institutions or other corporations sometimes 10 control firms; however, families use these controlling shareholder structures about 1.5-2 times as often as other types of owners (Cronqvist & Nilsson, 2003, p. 695). Pyramids or cascades are another form of control, though they are not as common in the United States as they are in Canada, Japan, and much of Europe. In this arrangement, one company, usually a private family-held company, has controlling (but not majority) shareholdings in a series of other companies, which may themselves have holdings in even more companies. Through this chain of companies, one family can exert influence over several companies without only a very small stake in those in its bottom tier ("Our company right or wrong," 2007). In theory, controlling minority shareholder structures could increase firm value. Without them, the family that controls the company would take measures to reduce the firm’s risk because their money is tied up in the firm. However, when their voting power exceeds their ownership stake, they can put more of their wealth in other places while retaining control of their company (Hagelin, Holmen, & Pramborg, 2006). Despite these potential benefits, the dual-class structure is more often blamed for bad firm performance, since it gives the family a great deal of control over the company while reducing their potential loss from making poor decisions. 3.3 The Board of Directors The board of directors serves as an important device through which the owners can regulate the managers’ actions. The board of directors has three main roles. First, it monitors management, which is why smaller shareholders are often wary of having too many representatives of the large shareholders (in this case the family) on the board. 11 However, it also has an advisory role. In this capacity, the directors on the board need to be friendlier with management so that their advice will be taken and information will not be hidden from them. In addition, the board may be seen as mediating between the different stakeholders in the firm, to make sure that neither shareholders nor the managers are excessively rent-seeking (Stout, 2003, p. 687). There are three groups represented on the board of directors: family members, affiliates of the company, and independent outsiders. Independent directors lack specific information about the company; they are often on the boards of several corporations and do not know the ins and outs of the business as well as other board members. As a result, they reward or discipline management based on objective measures while insiders may use more subjective measures (Baysinger & Hoskisson, 1990). Therefore, it is usually best to have more insiders on the board when the firm’s income is volatile or in highly technical industries (Bathala & Rao, 1995, p. 62). Members of the controlling family and affiliates of the company have more firm-specific knowledge, which makes their advice particularly valuable. A completely independent board is not ideal. In practice, the board’s monitoring role is often limited. To begin with, the CEO himself is often also the chairman of the board, and he can hardly be expected to adequately monitor himself. There are also often social ties between the CEO and the board. The CEO usually influences the selection of board members, and they may feel it necessary to reciprocate (Westphal, 1999, p. 8). Even if they were not friendly with the CEO before, once on the board, the directors may not want to antagonize the CEO because they have to deal with him again and again, so they may not restrain him as much as they should to best serve the firm’s owners. 12 3.4 Disciplining the large shareholder: Proxy fights and Takeovers Small shareholders are not completely powerless. Mechanisms for restraining the large shareholders include takeovers, where another company buys up the company, and proxy contests, where one shareholder attempts to change the management of the company by persuading small shareholders to use their proxy votes to change the board of directors. Successful proxy fights are relatively uncommon and expensive—dissident shareholders bear the costs of identifying the other shareholders, persuading them, and mailing ballots. If they are successful, these costs are often reimbursed by the company, but otherwise the dissident shareholder loses both the costs of the proxy fight and the possibility of changing the board (Hart, 1995; Ikenberry & Lakonishok, 1993). The number of successful proxy contests has been growing in recent years. Due to new corporate governance rules that offer investors greater power in selecting directors for the board and more moderate demands by activist investors themselves, shareholders have been gaining more board seats. In fact, since dissidents are more likely to win, many companies have simply conceded to their request for board seats without resorting to a proxy fight. In 2001, 61% of companies under pressure from dissident shareholders decided the matter through shareholder votes. That number fell to 32% last year (Dvorak & Lublin, 2008). Proxy fights are somewhat puzzling: if a shareholder is so displeased with the management, why would she not just sell her share? With a liquid stock market, this seems to make far more sense than bearing the costs of a proxy battle. However, the liquid stock market also makes it easier to buy a larger stake of the company, which in 13 turn increases the shareholder’s payoff when its profits rise through better management (Maug, 1998). The investors that start proxy fights are usually hedge funds, which have the money to do so and could benefit considerably from the rise in stock prices that often occurs when a company is targeted, as investors expect that the company will become better run (Whitehouse, 2007). The other method of controlling the family or other large shareholder is through takeovers. However, takeover bids are first presented to the board, and control over the board allows the family to reject bids that would perhaps increase the value of the company but reduce their control. The family may also keep information about the company’s internal workings away from the public so that possible buyers are uncertain about how much they can gain from purchasing the company. Large shareholders may also arrange governance to make it more difficult for small shareholders to remove the incumbent management without taking over. For instance, a majority of public US firms have staggered boards, where the directors that shareholders vote on cannot all be voted on at once. Shareholders who want to gain a majority on the board must then pay for a longer fight with the management (Bebchuk & Cohen, 2005, p. 410). Controlling minority shareholder arrangements also make takeovers more difficult. Since the controlling owner’s power outweighs his stake in the firm’s profits, he is less likely to accept a takeover offer. He gains only a little from the efficiency gains, since his share is only a fraction of the whole, but he loses all of the private benefits when the firm is taken over (Cronqvist & Nilsson, 2003, p. 699). 14 3.5 Collective action The family has another advantage over other shareholder groups in that their cost of collective action is lower than for other groups. The costs of organizing a group are foregone with the family, whereas other shareholders have to expend considerable effort to find the names of other shareholders and persuade them to join them in replacing board members (Olson, 1971, p. 47). In any group, problems arise when the actions of many members must be coordinated. In particular, when the benefits of an action will be distributed among many people, each may free-ride on the others’ effort. This causes a problem among the shareholders, where each shareholder is entitled to only a very small fraction of the firm’s income and cannot easily see what the others are doing (p. 45). As the family gets larger over time, it, too, can experience collective action problems, as different nuclear families can break into factions or some family members have more influence in the business than others. The family can, by acting together, exclude outside shareholders, if it is in their interest. If they can coordinate, they can more easily prevent takeovers or hire a CEO from within the family, which lets them keep control. As we shall see, family solidarity has kept Ford Motor Company in family control despite hard times, and infighting has prevented the Bancrofts of Dow Jones & Co. from preventing a takeover and later from choosing a strong representative to safeguard their interests on the board of the acquiring company, News Corp. 15