Enjoying the Quiet Life: Corporate Decision-Making by Entrenched Managers

Naoshi Ikeda is Assistant Professor, Kotaro Inoue is Professor, and Sho Watanabe is a Research Student at Tokyo Institute of Technology’s School of Engineering. This post is based on a recent paper by Professor Ikeda, Professor Inoue, and Mr. Watanabe. Related research from the Program on Corporate Governance includes The Costs of Entrenched Boards by Lucian Bebchuk and Alma Cohen; and What Matters in Corporate Governance? by Lucian Bebchuk, Alma Cohen and Allen Ferrell (discussed on the Forum here).

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

For decades, Japan has suffered from low corporate profitability, low economic growth, and poor stock market performance. Despite unprecedented and prolonged monetary policy meant to boost the economy, capital investments in the corporate sector have remained stagnant. Some have attributed the low profitability of Japanese firms to their failure to restructure and their aversion to risk (which, in turn, has suppressed innovation). The failure of firms to restructure and innovate may be related to the fact that managers’ interests may not always coincide with shareholders’ interests.

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

This quiet life hypothesis also can be extended to the disciplinary effect from the capital market. Bertrand and Mullainathan (2003) showed empirical evidence that is consistent with this extended version of the quiet life hypothesis. The quiet life hypothesis essentially predicts that managers avoid making difficult decisions when they are protected from the disciplinary effects of the capital market. Because increasing investments (e.g., new facility development, acquisitions, R&D) requires substantial effort on the part of managers, managers may decrease these investments, even if they are expected to increase firm value. Because many managers of Japanese firms are protected from the disciplinary effects of the stock market through cross-shareholding, the quiet life problem can be a cause of the poor performance of Japanese firms. Despite the importance of the quiet life problem, there has been no empirical study of the underinvestment problem caused by Japanese firm managers who entrenched themselves.

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

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

The complete paper is available for download here.

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