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Corporate governance in the deregulated telecommunications industry: lessons from the airline industry
Telecommunications Policy 26 (2002) 225–242
Corporate governance in the deregulated telecommunications industry: lessons from the airline industry Kenneth Lehn* University of Pittsburgh, KGSB—Business Admin Department, Pittsburgh, PA 15260, USA
Abstract Deregulation of the telecommunications industry is likely to result in significant changes in the governance structures of telecommunications firms. In particular, ownership structures of telecoms are expected to become more concentrated, the level of executive compensation is expected to increase, executive pay is expected to become more sensitive to performance, and board sizes are expected to become smaller. Evidence from the airline industry shows that these governance changes occurred after this industry was deregulated in the US in 1978. Preliminary evidence on telecommunications firms indicates that similar changes are beginning to occur in the governance structures of telecom firms. r 2002 Elsevier Science Ltd. All rights reserved. Keywords: Corporate governance; Deregulation; Telecommunications
1. Introduction Significant changes are likely to occur in the governance structures of telecommunications firms as the industry is increasingly freed from regulatory controls in the US and throughout the world. Deregulation is providing telecommunications firms with greater discretion to set prices, enter new markets, exploit new technologies, and make acquisitions. This enhanced discretion profoundly changes the role of managers, the nature of agency problems, and the relationship between stockholders, managers, and boards of directors, which is the essence of corporate governance.1 To understand the ways in which the governance structures of telecommunications firms are likely to change as deregulation continues to unfold, it is instructive to examine the experience of the US airline industry, which was deregulated in 1978. In a 1999 paper in the Journal of Financial Economics, Kole and Lehn find several significant changes in the governance structures of US *Tel.: +1-412-648-2034; fax: +1-412-624-2875. E-mail address: [email protected] (K. Lehn). 1 See Monks and Minow (1995, p. 1). 0308-5961/02/$ - see front matter r 2002 Elsevier Science Ltd. All rights reserved. PII: S 0 3 0 8 - 5 9 6 1 ( 0 2 ) 0 0 0 1 8 - 6
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airlines after deregulation, including more concentrated ownership structures, higher levels of CEO (chief executive officer) compensation, more stock-based compensation for CEOs, and smaller boards of directors. They also find that the governance structures of airlines gravitated towards those of unregulated firms, but only gradually, suggesting that it is costly for firms to abruptly change their governance structures. This paper reviews the evidence from the airline industry and discusses the implications of deregulation for the governance structures of telecommunications firms. In short, telecoms, like their counterparts in the airline industry, are likely to develop more nimble governance structures and rely more heavily on performance incentives for top executives as the industry is deregulated. The importance of nimbleness and strong incentives to create value in a deregulated telecommunications industry is illustrated by the recent dismissal of Sir Iain Vallance, chairman of British Telecom. One account reports that Sir Iain’s ouster was triggered by disgruntled British Telecom shareholders, who attribute the 64% decline in the company’s stock price since December 1999 to its ‘‘slow-moving, scatter shot strategy.’’2 Preliminary evidence from the US suggests that the governance structures of telecommunications firms are adapting to a less regulated business environment. As reported below, substantial changes are found in the level and structure of executive compensation at ATT and the surviving Baby Bells since the Telecommunications Reform Act of 1996 (‘‘TRA’’). In particular, the use of stock-based forms of compensation has increased sharply in these firms since 1996. Furthermore, these firms have contracted the size of their boards since the TRA, which is consistent with the argument that they are seeking nimbler governance structures. Part of the impetus for change in the governance structures of incumbent telecommunications firms is coming from new entrants into the industry. As shown below, the governance structures of new entrants are significantly different from those of incumbent firms, whose governance structures reflect the legacy of regulation. One of the major organizational challenges facing large, incumbent telecommunications firms, such as ATT and British Telecom, is adapting their governance structure from one that is suited for a regulatory environment to one that is appropriate for a rapidly changing, less regulated environment. The paper is organized as follows. In the next section, the general relation between deregulation and corporate governance is described. Specific attention is given to three dimensions of governance structure—the ownership structure of firms, the level and structure of executive compensation plans, and the size and structure of boards of directors. Section 3 describes the evidence that Kole and Lehn compile on the relation between deregulation and governance structure in the US airline industry. Section 4 presents some preliminary evidence on how the governance structures of US telecommunications firms have changed since the passage of the TRA. Section 5 concludes the paper.
2. Deregulation and corporate governance Deregulation of price and entry restrictions affects the optimal governance structures of firms in two ways. First, by giving more discretion to firms, deregulation increases the importance of the 2
Cowell (2001, p. C2).
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managerial function in firms. Because managers have more authority to establish prices and enter new markets in less regulated industries, the value of less regulated firms is more sensitive to managerial decisions. In short, the marginal revenue product of managers is greater in less regulated environments. Second, deregulation increases the costs of monitoring managerial performance. By removing the protective cover of regulation, deregulation injects uncertainty and instability into the business environment. Firms experiment with different pricing schedules, technologies, production processes, and asset mixes. Through luck or design, some firms succeed, while others fail. New firms enter the industry and old firms exit. Amidst this instability, investors face the challenge of determining how much of their firms’ success or failure is due to the actions of managers and how much is due to factors beyond the managers’ control. In short, the greater instability induced by deregulation increases the costs of observing managerial performance. By increasing the importance of the managerial function and making managerial performance less observable, deregulation increases the costs of monitoring managers. To mitigate the potential agency problems associated with higher monitoring costs, governance structures are likely to change after deregulation. In particular, three dimensions of governance structure are likely to change—ownership structure, executive compensation plans, and board structure. Each of these is discussed in turn. 2.1. Ownership structure Deregulation is expected to make ownership structures more concentrated in order to encourage socially valuable monitoring of managers by investor (Demsetz & Lehn, 1985). It is only rational for individual shareholders to monitor managers if the private costs of monitoring are less than the private benefits of monitoring. Individual shareholders bear the full costs of their monitoring, but capture only a proportion of the benefits associated with their monitoring. The proportion of the benefits they capture is equal to the proportion of the equity that they hold. Insofar that deregulation increases monitoring costs, ownership structures should become more concentrated after deregulation in order to encourage socially valuable monitoring. The increase in ownership concentration could occur through an increase in the percentage of equity held by officers and directors or outside blocks. The advantage of increased ownership concentration by officers and directors is that it economizes on the costs of outside monitoring. However, the disadvantage of increased ownership concentration by officers and directors is twofold. Officers and directors are likely to face wealth constraints that make it infeasible for them to own large percentages of stock in large firms. Furthermore, beyond some point, as a larger percentage of their wealth is tied up in the fortunes of their firms, managers can become excessively risk averse, i.e., more risk averse than their shareholders want. The advantage of outside blocks is that they face fewer wealth constraints than officers and directors and they are likely to be more diversified than officers and directors, thereby averting the agency costs associated with excessive risk aversion. However, the disadvantage of outside blocks is that they must incur monitoring costs that inside blocks can avoid. Presumably, the mix of inside and outside block ownership is governed by this tradeoff.
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2.2. Executive compensation Deregulation is expected to affect both the level and structure of executive compensation. As Smith and Watts (1992) argue, deregulation increases the scope and complexity of the managerial function. In order to attract and retain managers with the requisite skills, the level of executive compensation is expected to increase after deregulation. Deregulation also is expected to affect the forms in which executives are compensated. Smith and Watts (1992, p. 276) state that ‘‘regulation restricts [a firm’s] investment opportunity set and makes observation of the manager’s actions easier.’’ When the cost of observing managerial performance is high, investors can mitigate agency problems by rewarding managers with stockbased forms of compensation, such as executive stock options. Insofar as deregulation increases monitoring costs, firms will rely more on stock-based forms of compensation after deregulation than they did before deregulation. Joskow, Rose and Shephard (1993) offer other explanations for why there might be greater reliance on stock-based forms of compensation after deregulation. They argue that regulators may want managers to pursue goals other than value maximization, such as maintaining prices at low levels or providing services to remote markets. Furthermore, regulators may not allow managers to receive highly visible, large bonus payments, since such awards may be politically unpopular. Their arguments also lead to the prediction that stock-based forms of compensation should increase after deregulation. 2.3. Boards of directors Deregulation is likely to result in smaller boards of directors. Large boards foster free riding among board members, since the influence of any one board member is diluted as boards grow. As a result, large boards can impair the monitoring function of boards. Since the monitoring function of boards is more important in less regulated environments, board size is expected to contract after deregulation. Large boards also impede rapid decision-making, which can be important in deregulated environments. Speedy decisions about matters such as pricing, investments, and acquisitions can often govern which firms survive in a more competitive environment. Since smaller boards facilitate faster decision-making, boards should become smaller after deregulation. Deregulation also can change the mix of inside and outside directors. Some evidence suggests that outside directors serve an important monitoring role (e.g., Brickley, Coles & Terry, 1994). If so, the proportion of directors who are outsiders is expected to increase after deregulation, since the benefits of monitoring increase after deregulation.
3. Evidence from the airline industry The US airline industry provides a natural experiment for examining the relation between deregulation and corporate governance. The Airline Deregulation Act of 1978 eliminated price and entry restrictions that had governed the US airline industry since 1938. As
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Kole and Lehn argue, deregulation increased the importance of managers in the airline industry substantially. Competition shifted from non-price to price margins and airlines strove to quickly reduce their costs in order to survive in the new environment. In addition, airlines suddenly faced critical decisions about how to price their services, organize routes, compose aircraft fleets, control labor costs, develop distribution channels, and make acquisitions. 3.1. Deregulation and exit The allocation of assets in the airline industry changed substantially after deregulation. Only six of the 21 US airlines that were publicly traded at the time of deregulation in 1978 survived through 1992. Eleven of the 21 airlines were taken over and six filed for bankruptcy (two were both taken over and filed for bankruptcy). Furthermore, during the 15 yr before deregulation, firms with only 2% of the industry assets were taken over or filed for bankruptcy, versus 9% for unregulated manufacturing firms. The corresponding percentage increased to 59% in the 15 yr after deregulation, versus only 23% for unregulated manufacturing firms. These data suggest that deregulation injected considerable instability into the airline industry and resulted in a Darwinian experiment in which assets were reallocated to firms that adapted to the shock of deregulation most effectively. Kole and Lehn examine how the governance structures of airlines changed after deregulation. We examined longitudinal data for the 21 publicly traded airlines over a 22-yr period surrounding deregulation and compared changes in their governance structures with those of two benchmark samples consisting of regulated utilities and unregulated manufacturing firms. We focused on the three dimensions of governance described above—ownership structure, executive compensation, and board structure (Table 1).
Table 1 Summary of predictions and results on the relation between deregulation and corporate governance structures in the US airline industry from Kole and Lehn (1999) Governance variable
Predicted effect of deregulation
Evidence
Ownership structure
Becomes more concentrated
Executive compensation
Level of CEO compensation increases Reliance on stock-based compensation increases Frequency of CEO turnover increases Board size declines Fraction of board consisting of outside directors increases
Concentration of ownership by outside blocks increases Percentage of ownership by officers and directors does not change Level of CEO compensation increases Reliance on stock-based compensation increases Frequency of CEO turnover increases Board size declines No change in outside directors
Boards of directors
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Fig. 1. Line graphs showing mean annual values of equity ownership by insiders (panel a) and outside blockholders (panel b) for 21 airlines and two similarly sized benchmark samples (21 regulated utilities and 21 unregulated firms.) Data are drawn from corporate proxy statements for the 1971–1992 sample period. The shaded region covers the sample period prior to the airline Deregulation Act, 1971–1978, when carriers providing interstate passenger air service were regulated by the Civil Aeronautics Board. The ownership series for airlines are represented by solid lines, the series for regulated utilities with long dashes, and unregulated firms with short dashes.
3.2. Ownership structure The ownership structure of airlines became significantly more concentrated after deregulation. As Fig. 1 shows, little change is found in the percentage of equity held by officers and directors, but a significant increase is found in the percentage of equity held by outside blocks. During 1979–1992, a 14-yr period after deregulation, the percent of equity held by outside blocks increased by three percentage points for regulated utilities, seven percentage points for unregulated manufacturing firms, and nine percentage points for airlines. The results, significant at the 0.01%, are consistent with the hypothesis that deregulation increases the costs of monitoring, which causes ownership structures to become more concentrated. 3.3. Executive compensation 3.3.1. Level of executive compensation The level of total CEO compensation, which consists of cash compensation plus the value of stock-based forms of compensation (e.g., stock options), increased significantly in the airline industry after deregulation.3 The time pattern in the levels of CEO pay are plotted for the airlines and the two benchmark samples in Fig. 2. Compared with regulated utilities, the real value of CEO compensation (in constant 1982–1984 dollars) in the airline industry increased by approximately $300,000 per year, or more than 50%, after deregulation. This increase was 3
Kole and Lehn (1999) use the Black–Scholes option pricing model to value stock options granted to CEOs.
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Fig. 2. Line graphs showing mean annual levels of real CEO compensation (panel a) and component cash remuneration (panel b) and stock option awards (panel c) for 21 airlines and two similarly sized benchmark samples (21 regulated utilities and 21 unregulated firms.) Data are reported in 1982–1984 constant dollars and are drawn from corporate proxy statements for the 1971–1992 sample period. Constant dollars are drawn from corporate proxy statements for the 1971–1992 sample period. Stock option grants are valued using the Black–Scholes option pricing formula with standard deviations calculated with stock price data, drawn from SRSP, for the year prior to the year of the grant. The shaded region covers the sample period prior to the Airline Deregulation Act, 1971–1978, when carriers providing interstate passenger air service were regulated by the Civil Aeronautics Board. United Airlines’ 1988 and 1991 observations are excluded from the airline series in panels a and c. The airlines’ compensation series are represented by solid lines, the series for regulated utilities with long dashes, and unregulated firms with short dashes.
especially pronounced during the latter years of deregulation (i.e., 1986–1992), when CEO compensation in the airline industry increased by approximately $750,000 per year. The results (also significant at the 0.01 level) are consistent with the hypothesis that deregulation increases the marginal revenue product of managers, which results in higher levels of executive compensation. 3.3.2. Form of executive compensation The increase in the level of CEO compensation in the airline industry after deregulation is due to a substantial increase in the value of stock option grants rather than an increase in the cash
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compensation of CEOs. Fig. 2 plots the real value of stock option awards for CEOs in the airline sample and the two benchmark samples over time. Compared with regulated utilities, the value of stock option grants awarded to CEOs in the airline industry increased by approximately $260,000 per year over the 1972–1992 period. Even more striking, compared with regulated utilities and unregulated manufacturing firms, the value of stock options granted to airline CEOs increased by more than $700,000 and $400,000 per year, respectively, during the latter years of deregulation (i.e., 1986–1992). All of the results are significant at the 0.01 level. This evidence is consistent with the hypothesis that the use of stock-based forms of compensation increases after deregulation, presumably in response to the higher costs of monitoring managers in deregulated environments.
3.4. Boards of directors 3.4.1. Board size The size of boards in the airline industry declined significantly after the industry was deregulated in 1978. As seen in Fig. 3, the average size of boards in the airline industry fell from 13.8 before deregulation to roughly 11 after deregulation, a decline that is significant at the 0.01 level. Board size fell especially sharply during the latter years (i.e., 1986–1992) versus the earlier years (i.e., 1979–1985) of deregulation. In contrast, the boards of regulated utilities actually increased in size after airlines were deregulated. Board size among unregulated firms also fell after airlines were deregulated, but by only 0.6 members, which is significantly less than the decline in the size of airline boards. The evidence is consistent with the argument that deregulation results in
Fig. 3. Line graphs showing mean annual values of board size (panel a) and the fraction of board seats held by outsiders (panel b) for 21 airlines and two similarly sized benchmark samples (21 regulated utilities and 21 unregulated firms.) Data are drawn from corporate proxy statements for the 1971–1992 sample period. The shaded region covers the sample period prior to the Airline Deregulation Act, 1971–1978, when carriers providing interstate passenger air service were regulated by the Civil Aeronautics Board. The series on board size and composition for airlines are represented by solid lines, the series for regulated utilities with long dashes, and unregulated firms with short dashes.
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smaller boards, presumably to encourage more effective monitoring and speedier decisionmaking. 3.4.2. Outside versus inside directors The proportion of directors in the airline industry who are outsiders increases from 37% before deregulation to 41% after deregulation. However, as Fig. 3 reveals, the proportion of directors who are outsiders increased during this period for the two benchmark samples as well. The increase in the fraction of outside directors actually was significantly greater for the unregulated manufacturing firms than it was for the airlines over this period. The results indicate that deregulation had little effect on the use of outside directors in the US airline industry. One inference is that outside directors are not an effective monitoring device. Another inference is that other mechanisms, such as tighter ownership, more stock-based compensation, and smaller boards, are substitutes for outside directors. 3.5. Gradual vs. rapid change in governance structure The results from the airline industry generally show that governance structures changed in predictable ways after the industry was deregulated in 1978. However, the changes that Kole and Lehn document were much more pronounced in the last 7 yr of the deregulation period than the first 7 yr after deregulation. Ownership structures of airlines adapted most quickly, whereas executive compensation plans and board size adapted more sluggishly. The evidence suggests that there are costs associated with governance change, which impede the speed with which firms can adapt their governance structures to changes in the business environment. Kole and Lehn offer two explanations for why governance structures respond sluggishly to external shocks such as deregulation. The explanations pertain more to internal mechanisms such as compensation plans and board structure than they do to external mechanisms such as changes in ownership structure. First, firms develop corporate cultures that govern the expectations and behavior of employees. These cultures, which are reflected in compensation plans, operating procedures, and social norms within the firm, are by design difficult to change. Employees adjust their behavior to these incentives with expectations that there will be corresponding rewards for performing in desired ways. Presumably, firms select cultures that are appropriate for the environments in which they operate. However, their cultures may become less appropriate over time as their environments change, perhaps because of shocks such as deregulation. Yet, firm’s original culture may be perpetuated in the new environment because it is costly to reorient employees to a new set of incentives. Because of these costs, internal governance mechanisms are likely to respond sluggishly to changes in the business environment. Second, Kole and Lehn argue that changes in internal governance mechanisms often lead to wealth transfers among the various claimants in a firm. For example, if employees have holdup power (e.g., pilots in the airline industry) and stand to lose from a change in governance structure, they can impede the movement from one governance structure to another. Kole and Lehn contrast the governance structures of new, upstart airlines with those of incumbent airlines to test whether governance structures might exhibit some path dependence. Although there are only six upstarts in the sample, we found significant differences in their
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governance structures versus those of incumbent airlines. Controlling for differences in the size of the upstarts versus the incumbent airlines, we found that the new airlines had: (i) significantly smaller boards, (ii) a significantly higher fraction of outsiders on the board, (iii) significantly lower real compensation, and (iv) a significantly greater reliance on stock-based forms of compensation. Since the upstarts are able to develop governance structures from scratch, this evidence is consistent with the notion that corporate governance structures exhibit some degree of path dependence that inhibits firms from rapidly adjusting governance to sudden changes in the business environment.
4. Deregulation and corporate governance in the US telecommunications industry 4.1. Data and sample The US telecommunications industry was freed from a variety of regulatory restrictions in 1996 with the passage of the TRA. To examine whether the governance structure of US telecommunications firms has changed since this legislation, data are gathered from a variety of sources. A sample of telecommunications firms is identified from recent issues of Value Line, which is a weekly publication that provides information about individual firms every quarter. Specifically, 93 US firms are included in the sample, representing five industry groups, as defined by Value Line: telecommunications services (e.g., ATT, Verizon), telecommunications equipment (e.g., Juniper Networks, Lucent), wireless and networking (e.g., Palm, Handspring), entertainment (e.g., AOL Time Warner, Viacom), and cable (e.g., Cablevision, Comcast). The source of ownership data for the analysis that follows is Value Line. For each company, I recorded the percent of equity held by insiders and any outside blocks listed in the most recent issues of Value Line. To obtain information on executive compensation for the sample firms, Standard & Poor’s Executive Compensation database, which contains annual data on executive compensation for the period of 1992–1999, was consulted. Fifty-one of the 93 firms appear in Standard & Poor’s Executive Compensation database. Data on the total compensation paid and the value of stock options granted to the CEOs of these companies in each year was retrieved from this database. Total compensation is computed as the value of cash compensation plus the value of stock option grants. Standard & Poor’s Executive Compensation database uses the Black–Scholes model to value stock options. Data on boards of directors are taken from the most recent edition of Dun & Bradstreet’s Million Dollar Directory, which includes board data for the year 2000. The number of insiders (i.e., officers) and the total number of directors on the board in 2000 was recorded for each company in the sample. 4.2. Evidence on ATT and the surviving Baby Bells Arguably, ATT and the former Baby Bells have been most affected by deregulation of the US telecommunications industry. These firms had been subject to price and entry regulation for most
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of their existence prior to the breakup of the old AT&T in 1984 and continue to face considerable regulation by the Federal Communications Commission and state regulatory commissions to this day. Nonetheless, these firms were affected substantially by the TRA, which removed regulatory barriers to competition in the US telecommunications market. For reasons discussed above, it is expected that ATT and the Baby Bells will adapt their governance structures to suit the new, less regulated environment. Data on ownership structure, executive compensation, and board structure were collected for ATT and the three Baby Bells that survive as free-standing entities—BellSouth, SBC Communications, and Verizon. Preliminary results for each variable are reported in turn.
4.2.1. Ownership structure Based on the Value Line ownership data, there was no significant change in the ownership structure of ATT and the Baby Bells after the TRA. Value Line reported insider holdings of o1% and no outside blocks for each of the four companies in years before and after the TRA. Based on these data, it appears that no significant change occurred in the ownership structure of ATT and the Baby Bells after deregulation. This may be explained by the enormous market capitalization of the companies. The most recent issues of Value Line list the market capitalization of ATT, BellSouth, SBC Communications, and Verizon as $148 billion, $95 billion, $168.4 billion, and $189.7 billion, respectively. Therefore, a 5% stake in these companies, which is the threshold requirement for the stake to be disclosed to the Securities and Exchange Commission (SEC), requires an investment of $4.8 billion to $9.5, which might be prohibitive for even the largest mutual funds.
4.2.2. Executive compensation For each of the four companies, data on total CEO compensation and the value of stock options granted to the CEO in each year during 1994–1999 were collected from Standard & Poor’s Executive Compensation database. In the analysis that follows, all data are expressed in constant 1992 dollars. Fig. 4 shows the median value of total CEO compensation for ATT and the Baby Bells for each year, 1994–1999. The median value hovers at a little more than $6 million for each of the years, 1994–1996. In 1997, it increases to approximately $8 million. In 1998 and 1999, it jumps sharply to approximately $17 million. Hence, there is almost a threefold increase in the real total compensation of CEOs in ATT and the Baby Bells after the TRA. The data are consistent with the argument that the deregulation ushered in by the TRA increased the scope and complexity of the CEO positions in ATT and the Baby Bells, which led to an increase in their total compensation. The median proportion of total CEO compensation accounted for by stock option awards for the four companies is shown in Fig. 5. The figure shows that grants of stock options accounted for 27–31% of total CEO compensation before the TRA, but 35–49% of total CEO compensation after the TRA. This figure jumps dramatically in 1998 and remains at a high level in 1999. The data support the argument that deregulation results in greater reliance on stock-based forms of compensation for top executives.
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236 $20,000,000 $18,000,000 $16,000,000 $14,000,000 $12,000,000 $10,000,000 $8,000,000 $6,000,000 $4,000,000 $2,000,000 $0
1994
1995
1996
1997
1998
1999
Fig. 4. Median total compensation of CEOs for AT&T, Bellsouth, SBC Communications, and Verizon Communications (in 1994 dollars).
60%
50%
40%
30%
20%
10%
0% 1994
1995
1996
1997
1998
1999
Fig. 5. Median percentage of total CEO compensation accounted for by the value of stock options for AT&T, Bellsouth, SBC Communications, and Verizon Communications.
4.2.3. Board structure I collected data on the number of insiders and the total number of directors on the boards of ATT and the Baby Bells from Dun & Bradstreet’s Million Dollar Directory for 1992 and 2000. The data are reported in Table 2. As the table shows, ATT and the Baby Bells have contracted their board sizes substantially. ATT’s board size declined the most, from 18 in 1992 to 12 in 2000. On average, board size declined by 2.75 for the four companies, from 16.5 members in 1992 to 13.8 members in 2000. The
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Table 2 Number of directors and percent of directors who are insiders for AT&T, BellSouth, SBC Communications, and Verizon in 1992 and 2000, along with the changes in these variables from 1992 to 2000 Number of directors on board, 1992
Number of directors on board, 2000
Mean Median
18 15 17 16 16.5 16.5
12 13 14 16 13.8 13.5
Mean Median
Insiders as % of board, 1992 16.7 13.3 17.6 18.8 16.6 17.2
Insiders as % of board, 2000 16.7 7.7 7.1 12.5 11.0 10.1
AT&T BellSouth SBC Communications Verizon
AT&T BellSouth SBC Communications Verizon
Change
6 2 3 0 2.75 2.50 Change 0 5.6 10.5 6.3 5.6 5.9
data are consistent with Kole and Lehn’s results for airlines and suggest that the four telecommunications firms are striving for nimbler, more engaged, boards. Table 2 also shows that the proportion of insiders on the boards of ATT and the Baby Bells declined from 1992 to 2000. In 1992, insiders accounted for 16.6% of the board seats on average for the four companies. By 2000, this percent had fallen to 11%. Eleven insiders sat on the boards of the four companies in 1992. Only six insiders sat on their boards in 2000. These data are consistent with the argument that outside directors serve a more important monitoring function in a deregulated telecommunications market. 4.3. More systematic evidence A more systematic analysis of the relation between the TRA and the governance structures of telecommunications firms requires longitudinal data on ownership structure, executive compensation plans, and boards of directors for the expanded sample of telecommunications firms. This has not yet been done. However, longitudinal data on executive compensation is readily available from Standard & Poor’s Executive Compensation database for 51 of the 93 firms in the telecommunications sample. For each of these firms, data on total CEO compensation and the value of stock options awarded to the CEO in each year, 1992–1999, were collected. The values were adjusted for changes in the Consumer Price Index and expressed in constant 1992 dollars. Two fixed effects regressions are estimated. In the first regression, the natural log of total compensation serves as the dependent variable. In the second regression, the natural log of the percent of total CEO compensation accounted for by the value of stock option grants serves as the
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Table 3 Fixed effects regressions of the natural log of total chief executive officer (CEO) compensation and the proportion of total CEO compensation accounted for by stock option grants on dummy variables for whether year is for sample of 55 US telecommunications firms (t-statistics in parentheses)
Intercept Pre-TRA Post-TRA F-value testing whether coefficient estimates are significantly different from each other N R2
Dependent variable: log of total CEO compensation
Dependent variable: log of proportion of total CEO compensation accounted for by stock option grants
6.252 ( 3.2) 0.734 ( 1.7) 0.404 (1.0) 12.92
1.608 ( 0.5) 0.668 ( 1.0) 0.949 (1.4) 9.99
223 0.611
223 0.513
dependent variable. In both regressions, a dummy variable for each firm except one is included as an independent variable, in order to control for firm fixed effects. Two dummy variables also are included as independent variables, one for the period before the TRA of 1996 and one for the period after the TRA of 1996. The results from the two regressions are reported in Table 3. In the first regression, the coefficient on the pre-TRA dummy variable is –0.734 and significant at the 0.10 level. The coefficient on the post-TRA dummy is 0.404 and it is not significant. However, the F-statistic corresponding to the difference in the two coefficients is 12.9, indicating that the difference in the two coefficients is highly significant. This result is consistent with the hypothesis that the marginal revenue products of CEOs in the telecommunications industry increased after the passage of the TRA in 1996. However, because we do not have corresponding results for a control group, we cannot rule out the possibility that this result reflects a more general trend towards higher CEO compensation during the 1997–1999 period. The second regression reveals a significant increase in the proportion of CEO compensation accounted for by the value of stock option grants after the passage of the TRA. The coefficients on the pre-TRA and post-TRA dummy variables are –0.668 and 0.949, respectively, but neither one is significant. However, the F-statistic corresponding to the difference in the two coefficients is 9.99, indicating that the difference is highly significant. The results are consistent with the hypothesis that the TRA led to significantly more reliance on stock-based forms of compensation in the telecommunications industry. Without a control group, however, we again cannot rule out the possibility that the increased reliance on stock options reflects a more general trend and is not unique to the telecommunications industry. The evidence reported in Table 3 suggests that compensation plans adapted more quickly to deregulation in the telecommunications industry than they did in the airline industry 20 yr earlier.
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One possible explanation for this is that the market for corporate control is more robust today than it was 20 yr ago when the airline industry was deregulated. The increased threat of takeovers and proxy contests, along with the increased activism of shareholders, may be inducing swifter adaptation to changes in the business environment today (i.e., the costs of sluggish responses may be higher today than they were 20 yr ago). 4.4. Governance structure of new entrants versus incumbents A large number of newly formed firms have entered the telecommunications industry during the past decade. As in the airline industry, these firms are of special interest since they can develop their governance structures from scratch and in ways that are suited for the deregulated environment. Their larger counterparts, whose existence predates deregulation, initially adopted governance structures that were suitable for regulation, but presumably not for a deregulated environment. Their ability to move rapidly from one governance structure to another may be constrained by the organizational issues raised earlier. If so, governance structures may exhibit some degree of path dependence. One way of testing for path dependence is to contrast the governance structures of new entrants with those of incumbent telecommunication firms. In the sample of 93 telecommunications firms selected from Value Line, 37 were formed in 1990 or thereafter. I define this group as the ‘‘new entrants’’ and the remaining firms as the ‘‘incumbents.’’ Tables 4–6 report regression results that reveal whether new entrants differ significantly from incumbents in their ownership structure, executive compensation, and board structure, respectively. 4.4.1. Ownership structure Table 4 reports results from two regressions in which ownership structure variables serve as the dependent variables. In the first regression, the dependent variable is the natural log of the percent of equity held by officers and directors. In the second regression, the dependent variable is the natural log of the percent of equity held by outside blocks. The independent variables include the natural log of the market value of equity and dummy variables for whether the firm operates in one of five sectors of the telecommunications industry (equipment, wireless and networking, entertainment, cable, or services).4 In addition, a dummy variable for whether or not the firm is a new entrant is included as an independent variable. The results reveal that controlling for size and sector, new entrants have significantly more concentrated ownership structures than the incumbents. In the insider ownership equation, the coefficient on new entrants is 0.725 and significant at the 0.01 level. In the outside block equation, the coefficient on new entrants is 0.732 and significant at the 0.10 level. As expected, market value of equity enters both equations with negative and significant coefficients.5 The regression also reveals some differences across sectors of the telecommunications industry. Compared with firms 4
I follow Value Line’s classification of firms into different sectors of the telecommunications industry. We also entered the market value of equity and the market value of equity squared as independent variables in these regressions and those reported in Tables 5 and 6 to capture a possible non-linear relation between size and the governance variables. Specifying size in this way reduces the significance of the new entrant variable in the ownership equations but does not change its significance in the compensation and board equations. 5
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Table 4 OLS regressions of ownership variables on firm value, dummy variables for firms in telecommunications equipment, wireless and networking, entertainment, and cable, and a dummy variable for firms that were founded in 1990 or any year after 1990
Intercept Log of market value of equity Telecom equipment Wireless and networking Entertainment Cable New entrants N R2
Log of percent of equity held by officers and directors
Log of percent of equity held by outside blocks
3.850 (1.8) 0.300 ( 3.3) 0.330 ( 0.9) 0.208 ( 0.4) 1.143 (2.7) 1.637 (2.3) 0.725 (2.4) 93 0.246
4.241 (1.4) 0.339 ( 2.7) 0.516 ( 1.0) 1.270 ( 1.9) 0.878 (1.5) 0.098 (0.1) 0.732 (1.7) 93 0.145
Table 5 OLS regressions of executive compensation variables on firm value, dummy variables for firms in telecommunications equipment, wireless and networking, entertainment, and cable, and a dummy variable for firms that were founded in 1990 or any year after 1991
Intercept Log of market value of equity Telecom equipment Wireless and networking Entertainment Cable New entrants N R2
Log of total compensation
Log of percent of total compensation accounted for by stock options
10.9 (3.2) 0.216 (1.5) 0.699 ( 1.1) 1.319 ( 1.6) 1.103 ( 1.6) 0.053 ( 0.0) 0.555 ( 1.0) 47 0.247
4.618 ( 0.5) 0.072 (0.2) 0.118 (0.1) 0.825 ( 0.3) 0.979 ( 0.5) 0.228 (0.7) 0.547 ( 0.3) 47 0.031
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Table 6 OLS regressions of board of director variables on firm value, dummy variables for firms in telecommunications equipment, wireless and networking, entertainment, and cable, and a dummy variable for firms that were founded in 1990 or any year after 1992
Intercept Log of market value of equity Telecom equipment Wireless and networking Entertainment Cable New entrants N R2
Log of board size
Log of insiders as a percent of board
0.111 ( 0.1) 0.106 (2.4) 0.220 ( 1.2) 0.371 ( 1.6) 0.201 ( 1.0) 0.123 ( 0.4) 0.464 ( 3.2) 93 0.312
0.424 ( 0.4) 0.054 ( 1.1) 0.119 (0.6) 0.277 (1.1) 0.121 (0.6) 0.903 (2.6) 0.393 (2.5) 93 0.199
in telecommunication services, entertainment and cable companies have significantly more insider ownership and wireless and networking firms have significantly less ownership by outside blocks. 4.4.2. Executive compensation In Table 5, results from two executive compensation regressions are reported. In the first equation, the dependent variable is the natural log of total CEO compensation, defined as cash compensation plus the value of stock option awards. In the second equation, the dependent variable is the natural log of the percent of total CEO compensation accounted for by the value of stock option awards. The regressions reveal no significant difference in the level and structure of CEO compensation for the new entrants versus incumbents. In both equations the coefficient on new entrants enters negatively, but not significantly. The log of the market value of equity enters the total compensation regression with a positive coefficient that is significant at the 0.10 level, but it is not significant in the second regression. None of the sector dummies enters with a significant coefficient in either equation, indicating that the level and structure of CEO compensation does not vary much across sectors of the telecommunications industry. 4.4.3. Boards of directors Table 6 reports results from two regressions in which the dependent variables are the natural log of board size and the natural log of the percent of board members who are insiders. The table shows that new entrants have boards that are significantly smaller than those of the incumbents. The coefficient on new entrants is –0.464 and it is significant at the 0.01 level. The
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regression documents that larger firms have significantly larger boards and that wireless/ networking firms have smaller boards than other telecommunications firms, although this last result is barely significant. Table 6 also shows that insiders constitute a significantly larger percent of the board for new entrants versus the incumbents. The coefficient is 0.393, indicating that this is an economically meaningful difference. The only other coefficient that enters significantly is the dummy variable for cable firms, which enters with a coefficient of 0.903 that is significant at the 0.01 level. 5. Conclusion Telecommunications firms, like their counterparts in the airline industry, are excellent subjects for understanding the causes and consequences of different structures of corporate governance. The industry has experienced two major shocks in recent years, deregulation and major technological change, that are likely to cause their governance structures to change. The preliminary evidence presented in this paper suggests that the governance structures of incumbent firms have already begun to change in ways that promote nimbler decision-making and a closer correspondence of executive pay with firm performance. Furthermore, the governance structures of new entrants differ significantly from those of the incumbents, suggesting some path dependence in the governance structures of telecoms. As the industry continues to adapt to the new environment, it will be interesting to see if governance plays a role in distinguishing telecoms that survive from those that exit via takeover or bankruptcy. Acknowledgements I very much appreciate comments from Gershon Mandelker, Akin Sayrak, Frederik Schlingemann, Shawn Thomas, Francesc Trillas, two anonymous referees, and participants at the London Business School Conference on Corporate Control and Industry Structure in Global Communications for helpful comments. Mehmet Yalin provided valuable research assistance. References Brickley, J., Coles, J., & Terry, R. (1994). The board of directors and the adoption of poison pills. Journal of Financial Economics, 35, 371–390. Cowell, A. (2001). British Telecom chairman quits amid stockholder anger. The New York Times, April 27, C2. Demsetz, H., & Lehn, K. (1985). The structure of corporate ownership: Causes and consequences. Journal of Political Economy, 93, 1155–1177. Joskow, P., Rose, N., & Shephard, A. (1993). Regulatory constraints on CEO compensation. Brookings Papers on Economic Activity: Microeconomics, 1993, 1–58. Kole, S., & Lehn, K. (1999). Deregulation and the adaptation of governance structure: The case of the US airline industry. Journal of Financial Economics, 52, 79–117. Monks, R.A.G., & Minow, N. (1995). Corporate governance, Blackwell Business. Smith Jr., C. W., & Watts, R. L. (1992). The investment opportunity set and corporate financing, dividend, and compensation policies. Journal of Financial Economics, 32, 292.
Corporate governance in the deregulated telecommunications industry: lessons from the airline industry Kenneth Lehn* University of Pittsburgh, KGSB—Business Admin Department, Pittsburgh, PA 15260, USA
Abstract Deregulation of the telecommunications industry is likely to result in significant changes in the governance structures of telecommunications firms. In particular, ownership structures of telecoms are expected to become more concentrated, the level of executive compensation is expected to increase, executive pay is expected to become more sensitive to performance, and board sizes are expected to become smaller. Evidence from the airline industry shows that these governance changes occurred after this industry was deregulated in the US in 1978. Preliminary evidence on telecommunications firms indicates that similar changes are beginning to occur in the governance structures of telecom firms. r 2002 Elsevier Science Ltd. All rights reserved. Keywords: Corporate governance; Deregulation; Telecommunications
1. Introduction Significant changes are likely to occur in the governance structures of telecommunications firms as the industry is increasingly freed from regulatory controls in the US and throughout the world. Deregulation is providing telecommunications firms with greater discretion to set prices, enter new markets, exploit new technologies, and make acquisitions. This enhanced discretion profoundly changes the role of managers, the nature of agency problems, and the relationship between stockholders, managers, and boards of directors, which is the essence of corporate governance.1 To understand the ways in which the governance structures of telecommunications firms are likely to change as deregulation continues to unfold, it is instructive to examine the experience of the US airline industry, which was deregulated in 1978. In a 1999 paper in the Journal of Financial Economics, Kole and Lehn find several significant changes in the governance structures of US *Tel.: +1-412-648-2034; fax: +1-412-624-2875. E-mail address: [email protected] (K. Lehn). 1 See Monks and Minow (1995, p. 1). 0308-5961/02/$ - see front matter r 2002 Elsevier Science Ltd. All rights reserved. PII: S 0 3 0 8 - 5 9 6 1 ( 0 2 ) 0 0 0 1 8 - 6
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airlines after deregulation, including more concentrated ownership structures, higher levels of CEO (chief executive officer) compensation, more stock-based compensation for CEOs, and smaller boards of directors. They also find that the governance structures of airlines gravitated towards those of unregulated firms, but only gradually, suggesting that it is costly for firms to abruptly change their governance structures. This paper reviews the evidence from the airline industry and discusses the implications of deregulation for the governance structures of telecommunications firms. In short, telecoms, like their counterparts in the airline industry, are likely to develop more nimble governance structures and rely more heavily on performance incentives for top executives as the industry is deregulated. The importance of nimbleness and strong incentives to create value in a deregulated telecommunications industry is illustrated by the recent dismissal of Sir Iain Vallance, chairman of British Telecom. One account reports that Sir Iain’s ouster was triggered by disgruntled British Telecom shareholders, who attribute the 64% decline in the company’s stock price since December 1999 to its ‘‘slow-moving, scatter shot strategy.’’2 Preliminary evidence from the US suggests that the governance structures of telecommunications firms are adapting to a less regulated business environment. As reported below, substantial changes are found in the level and structure of executive compensation at ATT and the surviving Baby Bells since the Telecommunications Reform Act of 1996 (‘‘TRA’’). In particular, the use of stock-based forms of compensation has increased sharply in these firms since 1996. Furthermore, these firms have contracted the size of their boards since the TRA, which is consistent with the argument that they are seeking nimbler governance structures. Part of the impetus for change in the governance structures of incumbent telecommunications firms is coming from new entrants into the industry. As shown below, the governance structures of new entrants are significantly different from those of incumbent firms, whose governance structures reflect the legacy of regulation. One of the major organizational challenges facing large, incumbent telecommunications firms, such as ATT and British Telecom, is adapting their governance structure from one that is suited for a regulatory environment to one that is appropriate for a rapidly changing, less regulated environment. The paper is organized as follows. In the next section, the general relation between deregulation and corporate governance is described. Specific attention is given to three dimensions of governance structure—the ownership structure of firms, the level and structure of executive compensation plans, and the size and structure of boards of directors. Section 3 describes the evidence that Kole and Lehn compile on the relation between deregulation and governance structure in the US airline industry. Section 4 presents some preliminary evidence on how the governance structures of US telecommunications firms have changed since the passage of the TRA. Section 5 concludes the paper.
2. Deregulation and corporate governance Deregulation of price and entry restrictions affects the optimal governance structures of firms in two ways. First, by giving more discretion to firms, deregulation increases the importance of the 2
Cowell (2001, p. C2).
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managerial function in firms. Because managers have more authority to establish prices and enter new markets in less regulated industries, the value of less regulated firms is more sensitive to managerial decisions. In short, the marginal revenue product of managers is greater in less regulated environments. Second, deregulation increases the costs of monitoring managerial performance. By removing the protective cover of regulation, deregulation injects uncertainty and instability into the business environment. Firms experiment with different pricing schedules, technologies, production processes, and asset mixes. Through luck or design, some firms succeed, while others fail. New firms enter the industry and old firms exit. Amidst this instability, investors face the challenge of determining how much of their firms’ success or failure is due to the actions of managers and how much is due to factors beyond the managers’ control. In short, the greater instability induced by deregulation increases the costs of observing managerial performance. By increasing the importance of the managerial function and making managerial performance less observable, deregulation increases the costs of monitoring managers. To mitigate the potential agency problems associated with higher monitoring costs, governance structures are likely to change after deregulation. In particular, three dimensions of governance structure are likely to change—ownership structure, executive compensation plans, and board structure. Each of these is discussed in turn. 2.1. Ownership structure Deregulation is expected to make ownership structures more concentrated in order to encourage socially valuable monitoring of managers by investor (Demsetz & Lehn, 1985). It is only rational for individual shareholders to monitor managers if the private costs of monitoring are less than the private benefits of monitoring. Individual shareholders bear the full costs of their monitoring, but capture only a proportion of the benefits associated with their monitoring. The proportion of the benefits they capture is equal to the proportion of the equity that they hold. Insofar that deregulation increases monitoring costs, ownership structures should become more concentrated after deregulation in order to encourage socially valuable monitoring. The increase in ownership concentration could occur through an increase in the percentage of equity held by officers and directors or outside blocks. The advantage of increased ownership concentration by officers and directors is that it economizes on the costs of outside monitoring. However, the disadvantage of increased ownership concentration by officers and directors is twofold. Officers and directors are likely to face wealth constraints that make it infeasible for them to own large percentages of stock in large firms. Furthermore, beyond some point, as a larger percentage of their wealth is tied up in the fortunes of their firms, managers can become excessively risk averse, i.e., more risk averse than their shareholders want. The advantage of outside blocks is that they face fewer wealth constraints than officers and directors and they are likely to be more diversified than officers and directors, thereby averting the agency costs associated with excessive risk aversion. However, the disadvantage of outside blocks is that they must incur monitoring costs that inside blocks can avoid. Presumably, the mix of inside and outside block ownership is governed by this tradeoff.
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2.2. Executive compensation Deregulation is expected to affect both the level and structure of executive compensation. As Smith and Watts (1992) argue, deregulation increases the scope and complexity of the managerial function. In order to attract and retain managers with the requisite skills, the level of executive compensation is expected to increase after deregulation. Deregulation also is expected to affect the forms in which executives are compensated. Smith and Watts (1992, p. 276) state that ‘‘regulation restricts [a firm’s] investment opportunity set and makes observation of the manager’s actions easier.’’ When the cost of observing managerial performance is high, investors can mitigate agency problems by rewarding managers with stockbased forms of compensation, such as executive stock options. Insofar as deregulation increases monitoring costs, firms will rely more on stock-based forms of compensation after deregulation than they did before deregulation. Joskow, Rose and Shephard (1993) offer other explanations for why there might be greater reliance on stock-based forms of compensation after deregulation. They argue that regulators may want managers to pursue goals other than value maximization, such as maintaining prices at low levels or providing services to remote markets. Furthermore, regulators may not allow managers to receive highly visible, large bonus payments, since such awards may be politically unpopular. Their arguments also lead to the prediction that stock-based forms of compensation should increase after deregulation. 2.3. Boards of directors Deregulation is likely to result in smaller boards of directors. Large boards foster free riding among board members, since the influence of any one board member is diluted as boards grow. As a result, large boards can impair the monitoring function of boards. Since the monitoring function of boards is more important in less regulated environments, board size is expected to contract after deregulation. Large boards also impede rapid decision-making, which can be important in deregulated environments. Speedy decisions about matters such as pricing, investments, and acquisitions can often govern which firms survive in a more competitive environment. Since smaller boards facilitate faster decision-making, boards should become smaller after deregulation. Deregulation also can change the mix of inside and outside directors. Some evidence suggests that outside directors serve an important monitoring role (e.g., Brickley, Coles & Terry, 1994). If so, the proportion of directors who are outsiders is expected to increase after deregulation, since the benefits of monitoring increase after deregulation.
3. Evidence from the airline industry The US airline industry provides a natural experiment for examining the relation between deregulation and corporate governance. The Airline Deregulation Act of 1978 eliminated price and entry restrictions that had governed the US airline industry since 1938. As
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Kole and Lehn argue, deregulation increased the importance of managers in the airline industry substantially. Competition shifted from non-price to price margins and airlines strove to quickly reduce their costs in order to survive in the new environment. In addition, airlines suddenly faced critical decisions about how to price their services, organize routes, compose aircraft fleets, control labor costs, develop distribution channels, and make acquisitions. 3.1. Deregulation and exit The allocation of assets in the airline industry changed substantially after deregulation. Only six of the 21 US airlines that were publicly traded at the time of deregulation in 1978 survived through 1992. Eleven of the 21 airlines were taken over and six filed for bankruptcy (two were both taken over and filed for bankruptcy). Furthermore, during the 15 yr before deregulation, firms with only 2% of the industry assets were taken over or filed for bankruptcy, versus 9% for unregulated manufacturing firms. The corresponding percentage increased to 59% in the 15 yr after deregulation, versus only 23% for unregulated manufacturing firms. These data suggest that deregulation injected considerable instability into the airline industry and resulted in a Darwinian experiment in which assets were reallocated to firms that adapted to the shock of deregulation most effectively. Kole and Lehn examine how the governance structures of airlines changed after deregulation. We examined longitudinal data for the 21 publicly traded airlines over a 22-yr period surrounding deregulation and compared changes in their governance structures with those of two benchmark samples consisting of regulated utilities and unregulated manufacturing firms. We focused on the three dimensions of governance described above—ownership structure, executive compensation, and board structure (Table 1).
Table 1 Summary of predictions and results on the relation between deregulation and corporate governance structures in the US airline industry from Kole and Lehn (1999) Governance variable
Predicted effect of deregulation
Evidence
Ownership structure
Becomes more concentrated
Executive compensation
Level of CEO compensation increases Reliance on stock-based compensation increases Frequency of CEO turnover increases Board size declines Fraction of board consisting of outside directors increases
Concentration of ownership by outside blocks increases Percentage of ownership by officers and directors does not change Level of CEO compensation increases Reliance on stock-based compensation increases Frequency of CEO turnover increases Board size declines No change in outside directors
Boards of directors
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Fig. 1. Line graphs showing mean annual values of equity ownership by insiders (panel a) and outside blockholders (panel b) for 21 airlines and two similarly sized benchmark samples (21 regulated utilities and 21 unregulated firms.) Data are drawn from corporate proxy statements for the 1971–1992 sample period. The shaded region covers the sample period prior to the airline Deregulation Act, 1971–1978, when carriers providing interstate passenger air service were regulated by the Civil Aeronautics Board. The ownership series for airlines are represented by solid lines, the series for regulated utilities with long dashes, and unregulated firms with short dashes.
3.2. Ownership structure The ownership structure of airlines became significantly more concentrated after deregulation. As Fig. 1 shows, little change is found in the percentage of equity held by officers and directors, but a significant increase is found in the percentage of equity held by outside blocks. During 1979–1992, a 14-yr period after deregulation, the percent of equity held by outside blocks increased by three percentage points for regulated utilities, seven percentage points for unregulated manufacturing firms, and nine percentage points for airlines. The results, significant at the 0.01%, are consistent with the hypothesis that deregulation increases the costs of monitoring, which causes ownership structures to become more concentrated. 3.3. Executive compensation 3.3.1. Level of executive compensation The level of total CEO compensation, which consists of cash compensation plus the value of stock-based forms of compensation (e.g., stock options), increased significantly in the airline industry after deregulation.3 The time pattern in the levels of CEO pay are plotted for the airlines and the two benchmark samples in Fig. 2. Compared with regulated utilities, the real value of CEO compensation (in constant 1982–1984 dollars) in the airline industry increased by approximately $300,000 per year, or more than 50%, after deregulation. This increase was 3
Kole and Lehn (1999) use the Black–Scholes option pricing model to value stock options granted to CEOs.
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Fig. 2. Line graphs showing mean annual levels of real CEO compensation (panel a) and component cash remuneration (panel b) and stock option awards (panel c) for 21 airlines and two similarly sized benchmark samples (21 regulated utilities and 21 unregulated firms.) Data are reported in 1982–1984 constant dollars and are drawn from corporate proxy statements for the 1971–1992 sample period. Constant dollars are drawn from corporate proxy statements for the 1971–1992 sample period. Stock option grants are valued using the Black–Scholes option pricing formula with standard deviations calculated with stock price data, drawn from SRSP, for the year prior to the year of the grant. The shaded region covers the sample period prior to the Airline Deregulation Act, 1971–1978, when carriers providing interstate passenger air service were regulated by the Civil Aeronautics Board. United Airlines’ 1988 and 1991 observations are excluded from the airline series in panels a and c. The airlines’ compensation series are represented by solid lines, the series for regulated utilities with long dashes, and unregulated firms with short dashes.
especially pronounced during the latter years of deregulation (i.e., 1986–1992), when CEO compensation in the airline industry increased by approximately $750,000 per year. The results (also significant at the 0.01 level) are consistent with the hypothesis that deregulation increases the marginal revenue product of managers, which results in higher levels of executive compensation. 3.3.2. Form of executive compensation The increase in the level of CEO compensation in the airline industry after deregulation is due to a substantial increase in the value of stock option grants rather than an increase in the cash
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compensation of CEOs. Fig. 2 plots the real value of stock option awards for CEOs in the airline sample and the two benchmark samples over time. Compared with regulated utilities, the value of stock option grants awarded to CEOs in the airline industry increased by approximately $260,000 per year over the 1972–1992 period. Even more striking, compared with regulated utilities and unregulated manufacturing firms, the value of stock options granted to airline CEOs increased by more than $700,000 and $400,000 per year, respectively, during the latter years of deregulation (i.e., 1986–1992). All of the results are significant at the 0.01 level. This evidence is consistent with the hypothesis that the use of stock-based forms of compensation increases after deregulation, presumably in response to the higher costs of monitoring managers in deregulated environments.
3.4. Boards of directors 3.4.1. Board size The size of boards in the airline industry declined significantly after the industry was deregulated in 1978. As seen in Fig. 3, the average size of boards in the airline industry fell from 13.8 before deregulation to roughly 11 after deregulation, a decline that is significant at the 0.01 level. Board size fell especially sharply during the latter years (i.e., 1986–1992) versus the earlier years (i.e., 1979–1985) of deregulation. In contrast, the boards of regulated utilities actually increased in size after airlines were deregulated. Board size among unregulated firms also fell after airlines were deregulated, but by only 0.6 members, which is significantly less than the decline in the size of airline boards. The evidence is consistent with the argument that deregulation results in
Fig. 3. Line graphs showing mean annual values of board size (panel a) and the fraction of board seats held by outsiders (panel b) for 21 airlines and two similarly sized benchmark samples (21 regulated utilities and 21 unregulated firms.) Data are drawn from corporate proxy statements for the 1971–1992 sample period. The shaded region covers the sample period prior to the Airline Deregulation Act, 1971–1978, when carriers providing interstate passenger air service were regulated by the Civil Aeronautics Board. The series on board size and composition for airlines are represented by solid lines, the series for regulated utilities with long dashes, and unregulated firms with short dashes.
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smaller boards, presumably to encourage more effective monitoring and speedier decisionmaking. 3.4.2. Outside versus inside directors The proportion of directors in the airline industry who are outsiders increases from 37% before deregulation to 41% after deregulation. However, as Fig. 3 reveals, the proportion of directors who are outsiders increased during this period for the two benchmark samples as well. The increase in the fraction of outside directors actually was significantly greater for the unregulated manufacturing firms than it was for the airlines over this period. The results indicate that deregulation had little effect on the use of outside directors in the US airline industry. One inference is that outside directors are not an effective monitoring device. Another inference is that other mechanisms, such as tighter ownership, more stock-based compensation, and smaller boards, are substitutes for outside directors. 3.5. Gradual vs. rapid change in governance structure The results from the airline industry generally show that governance structures changed in predictable ways after the industry was deregulated in 1978. However, the changes that Kole and Lehn document were much more pronounced in the last 7 yr of the deregulation period than the first 7 yr after deregulation. Ownership structures of airlines adapted most quickly, whereas executive compensation plans and board size adapted more sluggishly. The evidence suggests that there are costs associated with governance change, which impede the speed with which firms can adapt their governance structures to changes in the business environment. Kole and Lehn offer two explanations for why governance structures respond sluggishly to external shocks such as deregulation. The explanations pertain more to internal mechanisms such as compensation plans and board structure than they do to external mechanisms such as changes in ownership structure. First, firms develop corporate cultures that govern the expectations and behavior of employees. These cultures, which are reflected in compensation plans, operating procedures, and social norms within the firm, are by design difficult to change. Employees adjust their behavior to these incentives with expectations that there will be corresponding rewards for performing in desired ways. Presumably, firms select cultures that are appropriate for the environments in which they operate. However, their cultures may become less appropriate over time as their environments change, perhaps because of shocks such as deregulation. Yet, firm’s original culture may be perpetuated in the new environment because it is costly to reorient employees to a new set of incentives. Because of these costs, internal governance mechanisms are likely to respond sluggishly to changes in the business environment. Second, Kole and Lehn argue that changes in internal governance mechanisms often lead to wealth transfers among the various claimants in a firm. For example, if employees have holdup power (e.g., pilots in the airline industry) and stand to lose from a change in governance structure, they can impede the movement from one governance structure to another. Kole and Lehn contrast the governance structures of new, upstart airlines with those of incumbent airlines to test whether governance structures might exhibit some path dependence. Although there are only six upstarts in the sample, we found significant differences in their
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governance structures versus those of incumbent airlines. Controlling for differences in the size of the upstarts versus the incumbent airlines, we found that the new airlines had: (i) significantly smaller boards, (ii) a significantly higher fraction of outsiders on the board, (iii) significantly lower real compensation, and (iv) a significantly greater reliance on stock-based forms of compensation. Since the upstarts are able to develop governance structures from scratch, this evidence is consistent with the notion that corporate governance structures exhibit some degree of path dependence that inhibits firms from rapidly adjusting governance to sudden changes in the business environment.
4. Deregulation and corporate governance in the US telecommunications industry 4.1. Data and sample The US telecommunications industry was freed from a variety of regulatory restrictions in 1996 with the passage of the TRA. To examine whether the governance structure of US telecommunications firms has changed since this legislation, data are gathered from a variety of sources. A sample of telecommunications firms is identified from recent issues of Value Line, which is a weekly publication that provides information about individual firms every quarter. Specifically, 93 US firms are included in the sample, representing five industry groups, as defined by Value Line: telecommunications services (e.g., ATT, Verizon), telecommunications equipment (e.g., Juniper Networks, Lucent), wireless and networking (e.g., Palm, Handspring), entertainment (e.g., AOL Time Warner, Viacom), and cable (e.g., Cablevision, Comcast). The source of ownership data for the analysis that follows is Value Line. For each company, I recorded the percent of equity held by insiders and any outside blocks listed in the most recent issues of Value Line. To obtain information on executive compensation for the sample firms, Standard & Poor’s Executive Compensation database, which contains annual data on executive compensation for the period of 1992–1999, was consulted. Fifty-one of the 93 firms appear in Standard & Poor’s Executive Compensation database. Data on the total compensation paid and the value of stock options granted to the CEOs of these companies in each year was retrieved from this database. Total compensation is computed as the value of cash compensation plus the value of stock option grants. Standard & Poor’s Executive Compensation database uses the Black–Scholes model to value stock options. Data on boards of directors are taken from the most recent edition of Dun & Bradstreet’s Million Dollar Directory, which includes board data for the year 2000. The number of insiders (i.e., officers) and the total number of directors on the board in 2000 was recorded for each company in the sample. 4.2. Evidence on ATT and the surviving Baby Bells Arguably, ATT and the former Baby Bells have been most affected by deregulation of the US telecommunications industry. These firms had been subject to price and entry regulation for most
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of their existence prior to the breakup of the old AT&T in 1984 and continue to face considerable regulation by the Federal Communications Commission and state regulatory commissions to this day. Nonetheless, these firms were affected substantially by the TRA, which removed regulatory barriers to competition in the US telecommunications market. For reasons discussed above, it is expected that ATT and the Baby Bells will adapt their governance structures to suit the new, less regulated environment. Data on ownership structure, executive compensation, and board structure were collected for ATT and the three Baby Bells that survive as free-standing entities—BellSouth, SBC Communications, and Verizon. Preliminary results for each variable are reported in turn.
4.2.1. Ownership structure Based on the Value Line ownership data, there was no significant change in the ownership structure of ATT and the Baby Bells after the TRA. Value Line reported insider holdings of o1% and no outside blocks for each of the four companies in years before and after the TRA. Based on these data, it appears that no significant change occurred in the ownership structure of ATT and the Baby Bells after deregulation. This may be explained by the enormous market capitalization of the companies. The most recent issues of Value Line list the market capitalization of ATT, BellSouth, SBC Communications, and Verizon as $148 billion, $95 billion, $168.4 billion, and $189.7 billion, respectively. Therefore, a 5% stake in these companies, which is the threshold requirement for the stake to be disclosed to the Securities and Exchange Commission (SEC), requires an investment of $4.8 billion to $9.5, which might be prohibitive for even the largest mutual funds.
4.2.2. Executive compensation For each of the four companies, data on total CEO compensation and the value of stock options granted to the CEO in each year during 1994–1999 were collected from Standard & Poor’s Executive Compensation database. In the analysis that follows, all data are expressed in constant 1992 dollars. Fig. 4 shows the median value of total CEO compensation for ATT and the Baby Bells for each year, 1994–1999. The median value hovers at a little more than $6 million for each of the years, 1994–1996. In 1997, it increases to approximately $8 million. In 1998 and 1999, it jumps sharply to approximately $17 million. Hence, there is almost a threefold increase in the real total compensation of CEOs in ATT and the Baby Bells after the TRA. The data are consistent with the argument that the deregulation ushered in by the TRA increased the scope and complexity of the CEO positions in ATT and the Baby Bells, which led to an increase in their total compensation. The median proportion of total CEO compensation accounted for by stock option awards for the four companies is shown in Fig. 5. The figure shows that grants of stock options accounted for 27–31% of total CEO compensation before the TRA, but 35–49% of total CEO compensation after the TRA. This figure jumps dramatically in 1998 and remains at a high level in 1999. The data support the argument that deregulation results in greater reliance on stock-based forms of compensation for top executives.
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236 $20,000,000 $18,000,000 $16,000,000 $14,000,000 $12,000,000 $10,000,000 $8,000,000 $6,000,000 $4,000,000 $2,000,000 $0
1994
1995
1996
1997
1998
1999
Fig. 4. Median total compensation of CEOs for AT&T, Bellsouth, SBC Communications, and Verizon Communications (in 1994 dollars).
60%
50%
40%
30%
20%
10%
0% 1994
1995
1996
1997
1998
1999
Fig. 5. Median percentage of total CEO compensation accounted for by the value of stock options for AT&T, Bellsouth, SBC Communications, and Verizon Communications.
4.2.3. Board structure I collected data on the number of insiders and the total number of directors on the boards of ATT and the Baby Bells from Dun & Bradstreet’s Million Dollar Directory for 1992 and 2000. The data are reported in Table 2. As the table shows, ATT and the Baby Bells have contracted their board sizes substantially. ATT’s board size declined the most, from 18 in 1992 to 12 in 2000. On average, board size declined by 2.75 for the four companies, from 16.5 members in 1992 to 13.8 members in 2000. The
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Table 2 Number of directors and percent of directors who are insiders for AT&T, BellSouth, SBC Communications, and Verizon in 1992 and 2000, along with the changes in these variables from 1992 to 2000 Number of directors on board, 1992
Number of directors on board, 2000
Mean Median
18 15 17 16 16.5 16.5
12 13 14 16 13.8 13.5
Mean Median
Insiders as % of board, 1992 16.7 13.3 17.6 18.8 16.6 17.2
Insiders as % of board, 2000 16.7 7.7 7.1 12.5 11.0 10.1
AT&T BellSouth SBC Communications Verizon
AT&T BellSouth SBC Communications Verizon
Change
6 2 3 0 2.75 2.50 Change 0 5.6 10.5 6.3 5.6 5.9
data are consistent with Kole and Lehn’s results for airlines and suggest that the four telecommunications firms are striving for nimbler, more engaged, boards. Table 2 also shows that the proportion of insiders on the boards of ATT and the Baby Bells declined from 1992 to 2000. In 1992, insiders accounted for 16.6% of the board seats on average for the four companies. By 2000, this percent had fallen to 11%. Eleven insiders sat on the boards of the four companies in 1992. Only six insiders sat on their boards in 2000. These data are consistent with the argument that outside directors serve a more important monitoring function in a deregulated telecommunications market. 4.3. More systematic evidence A more systematic analysis of the relation between the TRA and the governance structures of telecommunications firms requires longitudinal data on ownership structure, executive compensation plans, and boards of directors for the expanded sample of telecommunications firms. This has not yet been done. However, longitudinal data on executive compensation is readily available from Standard & Poor’s Executive Compensation database for 51 of the 93 firms in the telecommunications sample. For each of these firms, data on total CEO compensation and the value of stock options awarded to the CEO in each year, 1992–1999, were collected. The values were adjusted for changes in the Consumer Price Index and expressed in constant 1992 dollars. Two fixed effects regressions are estimated. In the first regression, the natural log of total compensation serves as the dependent variable. In the second regression, the natural log of the percent of total CEO compensation accounted for by the value of stock option grants serves as the
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Table 3 Fixed effects regressions of the natural log of total chief executive officer (CEO) compensation and the proportion of total CEO compensation accounted for by stock option grants on dummy variables for whether year is for sample of 55 US telecommunications firms (t-statistics in parentheses)
Intercept Pre-TRA Post-TRA F-value testing whether coefficient estimates are significantly different from each other N R2
Dependent variable: log of total CEO compensation
Dependent variable: log of proportion of total CEO compensation accounted for by stock option grants
6.252 ( 3.2) 0.734 ( 1.7) 0.404 (1.0) 12.92
1.608 ( 0.5) 0.668 ( 1.0) 0.949 (1.4) 9.99
223 0.611
223 0.513
dependent variable. In both regressions, a dummy variable for each firm except one is included as an independent variable, in order to control for firm fixed effects. Two dummy variables also are included as independent variables, one for the period before the TRA of 1996 and one for the period after the TRA of 1996. The results from the two regressions are reported in Table 3. In the first regression, the coefficient on the pre-TRA dummy variable is –0.734 and significant at the 0.10 level. The coefficient on the post-TRA dummy is 0.404 and it is not significant. However, the F-statistic corresponding to the difference in the two coefficients is 12.9, indicating that the difference in the two coefficients is highly significant. This result is consistent with the hypothesis that the marginal revenue products of CEOs in the telecommunications industry increased after the passage of the TRA in 1996. However, because we do not have corresponding results for a control group, we cannot rule out the possibility that this result reflects a more general trend towards higher CEO compensation during the 1997–1999 period. The second regression reveals a significant increase in the proportion of CEO compensation accounted for by the value of stock option grants after the passage of the TRA. The coefficients on the pre-TRA and post-TRA dummy variables are –0.668 and 0.949, respectively, but neither one is significant. However, the F-statistic corresponding to the difference in the two coefficients is 9.99, indicating that the difference is highly significant. The results are consistent with the hypothesis that the TRA led to significantly more reliance on stock-based forms of compensation in the telecommunications industry. Without a control group, however, we again cannot rule out the possibility that the increased reliance on stock options reflects a more general trend and is not unique to the telecommunications industry. The evidence reported in Table 3 suggests that compensation plans adapted more quickly to deregulation in the telecommunications industry than they did in the airline industry 20 yr earlier.
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One possible explanation for this is that the market for corporate control is more robust today than it was 20 yr ago when the airline industry was deregulated. The increased threat of takeovers and proxy contests, along with the increased activism of shareholders, may be inducing swifter adaptation to changes in the business environment today (i.e., the costs of sluggish responses may be higher today than they were 20 yr ago). 4.4. Governance structure of new entrants versus incumbents A large number of newly formed firms have entered the telecommunications industry during the past decade. As in the airline industry, these firms are of special interest since they can develop their governance structures from scratch and in ways that are suited for the deregulated environment. Their larger counterparts, whose existence predates deregulation, initially adopted governance structures that were suitable for regulation, but presumably not for a deregulated environment. Their ability to move rapidly from one governance structure to another may be constrained by the organizational issues raised earlier. If so, governance structures may exhibit some degree of path dependence. One way of testing for path dependence is to contrast the governance structures of new entrants with those of incumbent telecommunication firms. In the sample of 93 telecommunications firms selected from Value Line, 37 were formed in 1990 or thereafter. I define this group as the ‘‘new entrants’’ and the remaining firms as the ‘‘incumbents.’’ Tables 4–6 report regression results that reveal whether new entrants differ significantly from incumbents in their ownership structure, executive compensation, and board structure, respectively. 4.4.1. Ownership structure Table 4 reports results from two regressions in which ownership structure variables serve as the dependent variables. In the first regression, the dependent variable is the natural log of the percent of equity held by officers and directors. In the second regression, the dependent variable is the natural log of the percent of equity held by outside blocks. The independent variables include the natural log of the market value of equity and dummy variables for whether the firm operates in one of five sectors of the telecommunications industry (equipment, wireless and networking, entertainment, cable, or services).4 In addition, a dummy variable for whether or not the firm is a new entrant is included as an independent variable. The results reveal that controlling for size and sector, new entrants have significantly more concentrated ownership structures than the incumbents. In the insider ownership equation, the coefficient on new entrants is 0.725 and significant at the 0.01 level. In the outside block equation, the coefficient on new entrants is 0.732 and significant at the 0.10 level. As expected, market value of equity enters both equations with negative and significant coefficients.5 The regression also reveals some differences across sectors of the telecommunications industry. Compared with firms 4
I follow Value Line’s classification of firms into different sectors of the telecommunications industry. We also entered the market value of equity and the market value of equity squared as independent variables in these regressions and those reported in Tables 5 and 6 to capture a possible non-linear relation between size and the governance variables. Specifying size in this way reduces the significance of the new entrant variable in the ownership equations but does not change its significance in the compensation and board equations. 5
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Table 4 OLS regressions of ownership variables on firm value, dummy variables for firms in telecommunications equipment, wireless and networking, entertainment, and cable, and a dummy variable for firms that were founded in 1990 or any year after 1990
Intercept Log of market value of equity Telecom equipment Wireless and networking Entertainment Cable New entrants N R2
Log of percent of equity held by officers and directors
Log of percent of equity held by outside blocks
3.850 (1.8) 0.300 ( 3.3) 0.330 ( 0.9) 0.208 ( 0.4) 1.143 (2.7) 1.637 (2.3) 0.725 (2.4) 93 0.246
4.241 (1.4) 0.339 ( 2.7) 0.516 ( 1.0) 1.270 ( 1.9) 0.878 (1.5) 0.098 (0.1) 0.732 (1.7) 93 0.145
Table 5 OLS regressions of executive compensation variables on firm value, dummy variables for firms in telecommunications equipment, wireless and networking, entertainment, and cable, and a dummy variable for firms that were founded in 1990 or any year after 1991
Intercept Log of market value of equity Telecom equipment Wireless and networking Entertainment Cable New entrants N R2
Log of total compensation
Log of percent of total compensation accounted for by stock options
10.9 (3.2) 0.216 (1.5) 0.699 ( 1.1) 1.319 ( 1.6) 1.103 ( 1.6) 0.053 ( 0.0) 0.555 ( 1.0) 47 0.247
4.618 ( 0.5) 0.072 (0.2) 0.118 (0.1) 0.825 ( 0.3) 0.979 ( 0.5) 0.228 (0.7) 0.547 ( 0.3) 47 0.031
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Table 6 OLS regressions of board of director variables on firm value, dummy variables for firms in telecommunications equipment, wireless and networking, entertainment, and cable, and a dummy variable for firms that were founded in 1990 or any year after 1992
Intercept Log of market value of equity Telecom equipment Wireless and networking Entertainment Cable New entrants N R2
Log of board size
Log of insiders as a percent of board
0.111 ( 0.1) 0.106 (2.4) 0.220 ( 1.2) 0.371 ( 1.6) 0.201 ( 1.0) 0.123 ( 0.4) 0.464 ( 3.2) 93 0.312
0.424 ( 0.4) 0.054 ( 1.1) 0.119 (0.6) 0.277 (1.1) 0.121 (0.6) 0.903 (2.6) 0.393 (2.5) 93 0.199
in telecommunication services, entertainment and cable companies have significantly more insider ownership and wireless and networking firms have significantly less ownership by outside blocks. 4.4.2. Executive compensation In Table 5, results from two executive compensation regressions are reported. In the first equation, the dependent variable is the natural log of total CEO compensation, defined as cash compensation plus the value of stock option awards. In the second equation, the dependent variable is the natural log of the percent of total CEO compensation accounted for by the value of stock option awards. The regressions reveal no significant difference in the level and structure of CEO compensation for the new entrants versus incumbents. In both equations the coefficient on new entrants enters negatively, but not significantly. The log of the market value of equity enters the total compensation regression with a positive coefficient that is significant at the 0.10 level, but it is not significant in the second regression. None of the sector dummies enters with a significant coefficient in either equation, indicating that the level and structure of CEO compensation does not vary much across sectors of the telecommunications industry. 4.4.3. Boards of directors Table 6 reports results from two regressions in which the dependent variables are the natural log of board size and the natural log of the percent of board members who are insiders. The table shows that new entrants have boards that are significantly smaller than those of the incumbents. The coefficient on new entrants is –0.464 and it is significant at the 0.01 level. The
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regression documents that larger firms have significantly larger boards and that wireless/ networking firms have smaller boards than other telecommunications firms, although this last result is barely significant. Table 6 also shows that insiders constitute a significantly larger percent of the board for new entrants versus the incumbents. The coefficient is 0.393, indicating that this is an economically meaningful difference. The only other coefficient that enters significantly is the dummy variable for cable firms, which enters with a coefficient of 0.903 that is significant at the 0.01 level. 5. Conclusion Telecommunications firms, like their counterparts in the airline industry, are excellent subjects for understanding the causes and consequences of different structures of corporate governance. The industry has experienced two major shocks in recent years, deregulation and major technological change, that are likely to cause their governance structures to change. The preliminary evidence presented in this paper suggests that the governance structures of incumbent firms have already begun to change in ways that promote nimbler decision-making and a closer correspondence of executive pay with firm performance. Furthermore, the governance structures of new entrants differ significantly from those of the incumbents, suggesting some path dependence in the governance structures of telecoms. As the industry continues to adapt to the new environment, it will be interesting to see if governance plays a role in distinguishing telecoms that survive from those that exit via takeover or bankruptcy. Acknowledgements I very much appreciate comments from Gershon Mandelker, Akin Sayrak, Frederik Schlingemann, Shawn Thomas, Francesc Trillas, two anonymous referees, and participants at the London Business School Conference on Corporate Control and Industry Structure in Global Communications for helpful comments. Mehmet Yalin provided valuable research assistance. References Brickley, J., Coles, J., & Terry, R. (1994). The board of directors and the adoption of poison pills. Journal of Financial Economics, 35, 371–390. Cowell, A. (2001). British Telecom chairman quits amid stockholder anger. The New York Times, April 27, C2. Demsetz, H., & Lehn, K. (1985). The structure of corporate ownership: Causes and consequences. Journal of Political Economy, 93, 1155–1177. Joskow, P., Rose, N., & Shephard, A. (1993). Regulatory constraints on CEO compensation. Brookings Papers on Economic Activity: Microeconomics, 1993, 1–58. Kole, S., & Lehn, K. (1999). Deregulation and the adaptation of governance structure: The case of the US airline industry. Journal of Financial Economics, 52, 79–117. Monks, R.A.G., & Minow, N. (1995). Corporate governance, Blackwell Business. Smith Jr., C. W., & Watts, R. L. (1992). The investment opportunity set and corporate financing, dividend, and compensation policies. Journal of Financial Economics, 32, 292.