Transcript Codes of Best Practice in Competitive Markets

Codes of Best Practice in
Competitive Markets for Managers
Eduard Alonso-Paulí
Universidad Pablo Olavide, Sevilla
David Pérez-Castrillo
Universitat Autònoma de Barcelona
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Codes of Best Practice
A Code of Best Practice
is a list of rules of voluntary adoption promoted by a
regulator suggesting how a firm should supervise
management
Codes were promoted after Financial Scandals at the
end of 80s. Institutions considered that these collapses
were a lack of corporate governance.
Committee made recommendations on “good practices”:
the Cadbury Report, including a Code of Best Practice.
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…Codes of Best Practice…
The main recommendations of the Cadbury Report:

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Separation of CEO and COB
At least three independent directors
Creation of Committees (Audit, Nomination or
Remuneration)
Objective?  Reduction of the power of
Executive Directors (Dahya et al.,2002)
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On the other hand
“There is danger in an over-emphasis on monitoring;
on non-executive directors' independence from the
business of the corporation; on controls over decision
making activities of companies. When coupled with the
clearly reduced status of executives on the governing
boards, such requirements must blunt the competitive
edge and deflect the entrepreneurial drive which
characterises participation, let alone success, in a free
market.”
(Sir Owen Green
former BTR chairman, February 25, 1994)
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Our simplified view
We view a CBP as a mechanism that:

Allows the shareholder a better control of manager’s
actions.

Reduces flexibility at the manager’s decision level.
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Basic characteristics

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Each shareholder can hire one manager to conduct
her project
Success depends on manager’s effort and on
market conditions
Both shareholder and manager know the (ex-ante)
distribution of the market conditions
Only the manager learns the actual realization of the
market conditions once the contract is signed
Agency model, but a CBP can be introduced:

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No CBP: Incentive contract
CBP: The effort is contractual and fixed ex-ante
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The trade-off
Introducing the Code of Best Practice:
Eliminates the cost of the Moral Hazard
problem through monitoring
Decreases the flexibility at the manager’s
decision level: the manager can not adapt his
decision to market conditions
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Aim of the paper

We analyze the adoption of Codes of Best
Practice in environments where shareholders
compete for managers, in order to study:
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When firms choose to adopt a CBP
Whether this adoption depends on the structure of the
market (characteristics of managers and
shareholders), and how.
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The Model

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n risk neutral Shareholders S = {s1, s2,..., sn} have access each to
a project with whose value in case of success is R1 ≥ R2 ≥ ... ≥
Rn.
N risk neutral Managers M = {m1, m2,..., mN} subject to limited
liability. They are endowed with (possibly) different abilities: The
cost for manager mj of exerting effort e is cj(e) = cj e2/2, with 0 <
c1 ≤ c2 ≤ ... ≤ cN.
A Firm (si, mj) is constituted when a manager-shareholder pair is
formed (through a contract). Both shareholder and managers can
seek for alternative partners (endogenous matching).
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…the model…
Once a firm (si, mj) is formed, the probability of success depends
on two elements:


the effort e exerted by the manager
the market-specific conditions h
he
Ri
(1  he)
0
The parameter h
 is random ex-ante
 is known ex-post only by the manager
 is distributed according to F(h), with mean a(h) and variance
Var(h)
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…the contract…

The contract includes the governance structure
(CBP or Incentives)
WsISi ,m j  (wR , w0 )
WsCBP
 (wR , w0 , e)
i ,m j
a (h) Ri
CBP
h
e (h)  ( wR  w0 )
e 
cj
cj
A pair (si , m j ) signs only feasible contracts,
IS

 s (m j ,Ws ,m )  0 and Vm ( si ,Ws ,m )  U
i
i
j
j
i
j
wR  0 and w0  0
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Outcome and stability

An outcome for this market is a matching
and a menu of contracts compatible with
the matching

Besides, the outcome shall be stable
(competitive equilibrium)
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Contracts in a Stable Outcome
Outcomes involve a matching between shareholders
and managers and a contract that governs each
firm.
A first property of each of those contracts
All the contracts in a stable outcome
are Pareto optimal.
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…optimal contracts…
We can characterize any contract in a stable
outcome as a function of the shareholder-manager
pair (si, mj) and on the "minimum" utility Uj that has
to be achieved by the manager.
Two possibilities:
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Contracts in a Stable Outcome
s
i
 sCBP
i
 sIS
i
Uˆ ij
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A firm is more prone to
adopt a CBP for: (1)
environments with low
variance,
(2)
low
manager’s utility, (3) low
effort’s cost, (4) better
projects
Uj
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We now discuss:
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Two simple scenarios.
Whether good shareholders end up hiring
high-quality managers.
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Homogeneous Shareholders and
Heterogeneous Managers
R1 R2  ...  R n and c1  c2  ...  cN
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What are the characteristics of a stable outcome?

 high
 inter
 low
CBP
" Good" M. via IC
" Bad" M. via CBP
Incentive C
Low Variance
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Incentive C
High Variance
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Var(h)
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Note: High-ability managers are hired through
Incentive contracts while a CBP is used to attract
low-ability managers.
This contrasts with the conclusion in the analysis of
a single contract.
When shareholders compete for the best
managers, they offer a high utility level to highability managers and this makes Incentive
contracts more appealing than contracts with
CBPs.
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Heterogeneous Shareholders and
Homogeneous Managers
R1  R2  ...  Rn and c1  c2  ...  cN

What are the characteristics of the stable outcome?
U
U high
U inter
U low
Incentive C
" Good"S. offerCBP
" Bad" S. offeran IC
CBP
Low Variance
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Incentive C
High Variance
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Var(h)
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Heterogeneous Shareholders and
Homogeneous Managers
Ex-ante homogeneous managers end up with very different utilities
Ui
Differences in the ex-post
utilities
due
to:
(1)
shareholders’ heterogeneity
and (2) the governance
relationship (CBP or IC)
Uˆ1
Uˆ 2
Uˆ I 1
Uˆ I
Uˆ i 1
Uˆ
i
U
Rn
Rn1
RI
Incentive contract
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RI 1
R2
R1
Ri
CBP contract
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more about the matching
A matching is positively assortative if shareholders
with higher-revenue projects are matched with more
efficient managers.
Is the matching in a stable outcome always positively
assortative?
Often:
If (m, W) is a stable outcome and in W they
are all Incentive contracts, or they all
include a CBP, then
m is positively assortative.
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…more about the matching…
How does a non-possitively assortative matching in a stable
outcome look like?
if si = mj and si’ = mj’ with Ri > Ri’ and cj > cj’ then
si and mj sign a contract including a CPB while
si’ and mj’ sign an Incentive contract.
In a non-possitively assortative matching in a stable outcome,
shareholders with profitable projects hire low-ability managers
through CBPs while high-ability managers sign Incentive
contracts in less profitable firms.
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…more about the matching…
In our model, maximizing the total surplus requires a
positively assortative matching.
However,
 the better the shareholder the more prone she is to
adopt a CBP.
 The better the manager, the more convenient is to use
an Incentive Scheme
In some cases, this trade-off leads to non-positively
assortative matchings.
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Conclusions
1. Under volatile environments (it is difficult to estimate
market conditions), firms are not prone to adopt CBP
2. Environments with Heterogeneous shareholders and
Homogeneous managers:
- CBP is a mechanism used by the best shareholders to
hire managers
3. Environments with Homogeneous Shareholders and
Heterogeneous managers:
- CBP is used to attract the worst managers
4. The coexistence of CBP and Incentive contracts may
lead to negative assortative matchings
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Some literature on CBPs

Empirical papers give mixed evidence:
 Dahya et al. (JF 2002)
Fernández & Gómez (2002)
Positive effect of the adoption of CBP for UK and Spain.
 Nowak, Rott & Mahr (2004)
 de Jong, DeJong, Mertens & Wasley (JCF 2005)
No effect of the adoption for Germany and The Netherlands.
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Theoretical paper:
 Alonso-Paulí (2006)
Studies the adoption decision and the design by a regulator.
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Some literature on the framework
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Assignment model:
 Shapley & Shubik (IJGT 1972)
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Roth & Sotomayor (1990)
Approach also adopted in:
 Dam & Pérez-Castrillo (FET 2006)
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Serfes (IJGT 2007)
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