4. Corporate governance

Question 1

Extreme Governance: An Analysis of Dual-Class Companies in the United States

1. Why are one-share-one-vote shares valued less in the dual-class system?
2. How does this affect external financing of the firm?

Answer 1

1. This is because inferior shareholders have less control and thus can be more easily expropriated leading to worse performance of the firm. Superior shareholders, on the other hand, enjoy PBOC
2. Firms with dual-class system is more reluctant to engage in equity offerings not to lose ownership (therefore, they are more leveraged: higher debt-to-assets ratio comparing with singe-class firms)

Question 2

Extreme Governance: An Analysis of Dual-Class Companies in the United States

What are five predictors for larger size of PBOC and thus dual-class status and why?

Answer 2

1. Name. If the company is named after a founder, this might indicate a “personal” stake involved.
2. Media. Control of a media company (e.g. newspaper, TV network) provides opportunities for self-advertising, manipulating the public opinion, etc.
3. Activity of the founder. If the firm is young and the founder is still active, PBOC and also dual-class structure is more likely.
4. Number of firms in the area. The less firms there are in firm’s metropolitan area, the more likely the firm is a major employer and “the only game in town”, which entails private benefits for insiders with dual-class shares
5. Sales of the area. The larger turnover firms in the area generate, the more powerful potential acquirers there are, from whom it is necessary to defend via dual-class structure.

Question 3

“A Survey of Corporate Governance”

Please discuss the advantages and disadvantages of having large shareholders and large creditors. (4p)

Answer 3

LARGE SHAREHOLDERS
+CF rights and control rights of large shareholders are better aligned, preventing free-rider problems
+Can exert pressure on managers and even oust them out through a proxy fight or a takeover
- profit oriented, lower quality of product/service provided
-Large shareholders might seek the firm to pursue risky projects, as they face upward payoff
-Power depends on the legal protection of their votes
- might pursue their own interests and expropriate other stakeholders (e.g. special dividends, pollutions in oil companies)
- large institutional investors might be too soft due to their own agency problems

=> Large investors bear larger financial consequences of their actions due to lack of diversification. Risky game!

LAGE CREDITORS
+ when lenders (banks, especially) have almost monopoly control of the firm in the case of default, jointly carried out action by multiple creditors is not required.
- Debt covenants pressure the managers

Question 4

“A Survey of Corporate Governance”

Describe the major conflicts of interests that can arise (i) between managers and shareholders of a firm, and (ii) between majority and minority shareholders, respectively, given that investors want to ensure a fair return on their investment. Explain why signing a contract between managers and shareholders of a firm is only a partial solution to potential corporate governance problems. (6p)

Answer 4

answer

Question 5

“A Survey of Corporate Governance”

Argue for or against the argument that finance cannot persist without legal protection of investors. Explain which other mechanisms of corporate governance are discussed by authors.

Answer 5

answer

Question 6

“A Survey of Corporate Governance”

You have just read an article in the local newspaper where M. Blomkvist, a young financial journalist, has criticized managers of Acebook for reinvesting company resources in negative NPV projects, instead of returning them to shareholders. Name and briefly explain a theory which supports this observation? What other empirical evidence of managers engaging in shareholder value-destroying activities is presented? (5p)

Answer 6

answer

Question 7

“A Survey of Corporate Governance”

Present and discuss the potential positive and negative effects of privatization on the efficiency of state owned enterprises identified! In particular, what negative effects and under what conditions can privatization have? (6p)

Answer 7

+ Brings CF and Voting rights together again;

• If rights not protected–agency costs increase!
• New managers might not be competent to restructure company (need large investors to fire them!).

Question 8

“A Survey of Corporate Governance”

The essence of the agency problem is the separation of management and finance or ownership and control. Discuss three different agency costs that may arise due to this problem. Provide a short explanation for each one of them. (6p)

Answer 8

1) If the stock price falls when managers announce a particular action, this action must serve the interest of managers rather than shareholders. For example, acquisition decisions!
2) Manager’s resistance to the value-enhancing takeover signals the existence of PBOC and thus agency problems.
3) Large blocks of shares carry more control and thus trade at a large premium. Large blockholders receiving special benefits(?).

Question 9

“Private Benefits of Control”

Name and briefly explain four ways to improve the corporate governance. (4p)

Answer 9

1. Add another large shareholder block.
   (30% block with the presence of another 20%-shareholder carries less control than if the remaining shareholders are dispersed. Thus, other large shareholders reduce PBOC and premium paid as well.)

Question 10

“Private Benefits of Control”

Explain the term private benefits of control. State the effects of private benefits on financial development! (6p)

Answer 10

PBOC – benefits that are not shared among all shareholders in proportion of the shares owned, but are exclusively enjoyed by parties in control.

Effects on financial development:

1) In countries showing high PBOC, entrepreneurs are reluctant to make their companies public.
2) Potential buyers of smaller stakes also attribute less value to shares taking into account being exploited by majority shareholders.
3) Selling control in private negotiation is more profitable than in the market with dispersed buyers buying many non-controlling stakes.

Question 11

“A Survey of Corporate Governance”

The article raise a question: which corporate governance system is the best: (a) the United States, (b) Germany and Japan, (c) the rest of the world. Briefly explain the main differences between legal protection mechanisms, presence of large investors and why such developments have taken place in each of the regions. Conclude by providing an answer to the question of which system is the best. (6p)

Answer 11

answer

Question 12

“A Survey of Corporate Governance”

What is a ‘Leveraged Buyout - LBO’

Answer 12

A leveraged buyout (LBO) is the acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital.
A unified group of investors can now control firm’s decisions. No free-rider problem.

Question 13

“A Survey of Corporate Governance”

What is the problem with state ownership and cooperatives?

Answer 13

CG perspective: bureaucrats in control of state enterprises can be though of as having concentrated voting rights, but no significant CF rights. Respective agency problems arise.
Goals for the bureaucrats are not determined by social needs, but rather by political interests (catering their lobbyists).

Question 14

“Private Benefits of Control”

What are the 2 ways of measuring PBOC?

Answer 14

1. Control premium - the difference between the price per share of the control block and the market price per share. Drawbacks: Sales of control blocks are rather rare; delay in incorporating public information to the market price.
2. Price difference between shares in a dual-class system. Extra voting rights as a proxy for corporate control. Drawback: dual class shares are not allowed in every country.

IF PBOC were easily observable and quantifiable, they would not be private and would be claimed by minority shareholders in court.

Family business are rarely acquired, thus benefits of running a family business hardly manifest themselves in the market.

Question 15

“Private Benefits of Control”

What are the 3 implications which apply to countries with high PBOC?

Answer 15

1. Fewer companies are public, thus the equity markets are underdeveloped which limits firm financing.
2. Afraid of ending up in the minority position, incumbents (the person who has a particular official position) seek to retain control after going public, thus there should be less widely held companies.
3. To maximise profit, governments should sell companies privately rather than in public offerings.

Question 16

“Private Benefits of Control”

What restrains PBOC?

• 3 arguments for legal institutions
• 5 arguments for extra-legal institutions

Answer 16

Legal institutions:

1. The legal environment. Greater ability to sue controlling shareholders and greater shareholder protection in general translate into smaller PBOC.
2. Disclosure standards. The more extensive and accurate disclosed informaKon is, the more it curbs appropriaKon by increasing the risk of legal consequences or reputaKonal costs (SEC in the US).
3. Enforcement (compliance with the law). Quicker, smoother and more predictable enforcement, the stronger the legal protections of shareholders (e.g. the level of corruption and bureaucracy of courts in the country).

Extra-Legal institutions:
1. Market competition.
Through prices, competitive markets can verify manipulated transfer prices. Competition also makes tunneling more harmful to firm’s survival.
2. Public opinion pressure. Value appropriation can be limited by expected reputational costs.
3. Moral norms.
Moral considerations restrain value appropriation. (Religion)
4. Labor unions as monitor. The risk of employees quitting due to dishonest activities by majority shareholders. What if employees benefit from PBOC?
5. Government as a monitor through tax enforcement. Through taxes the state is an investor to all companies. It also has a power unavailable to regular shareholders – before tax enforcement can reduce PBOC.

Question 17

“Coase versus the Coasians”

State the Coase Theorem.
Show under what conditions Coase Theorem does not hold in financial markets. (6p)

Answer 17

Coase theorem:
when property rights are well defined and transaction costs are zero, market participants’ use of contracts will achieve Pareto efficient outcomes.
§ In such an ideal world, there is no need for the government to interfere through taxes or regulations. If the assumptions are not satisfied, intervention is inevitably needed.
§ The Coasians have deviated from the original Coase theorem. According to them, contractors (e.g. security buyers and sellers) have a vast range of types of contracts to ensure that all possible scenarios can be dealt with by their provisions.
§ Such contracts make most laws and regulations unnecessary. Ex- post judicial enforcement is enough to ensure efficient markets.
§ The Coasian judges must be able and willing to read complicated contracts, verify that their provisions have been breached and interpret broad and ambiguous language (!).

How realistic are the coasians? - not too much.

1) Security issuers might expropriate the buyers by misrepresenting financial information. Buyers would fear this, restraining external finance to the firms.
2) Financial contracts contain many ambiguities. Does the manager “abuse minority shareholders” or just following her best judgment? Does he trade on the “inside information” or is simply lucky?
3) Courts in many countries are underfinanced to perform due diligence, lacking specific knowledge or experience, unclear how the law applies and/or corrupt, which undermine their ability to engage in complicated cases.
4) Interpretation of contract provisions require powerful resources and incentives to motivate an adjudicator. Absent such incentives, courts postpone decisions, let violators go and punish the innocent.

Question 18

“Coase versus the Coasians”

Article asks the question—which is better: the judiciary or a government regulator? What are the main differences between a government regulator and a judge? Which and in what circumstances is better? Why? (6p)

Answer 18

Enforcement by judges means less government regulation (laissez faire), while regulators are typically governmental organizations (e.g. SEC) intervening in the market using policies.

JUDGES
+ Judges are more independent from political agendas. It means that while judges are hardly incentivized to punish violations of particular statutes, they are also less biased in their judgment.

REGULATORS
+ Even though judges can be specialized to some extent (e.g. family law), regulators in general possess higher specialization which enables them to enforce more complicated cases and allows for lower search of investigation.
- Established in pursue of certain policies, regulators seek to punish particular violations, as their careers depend on that. Thus, they can engage in more aggressive enforcement relative to the courts at the expense of doing actual justice.

=> Government, broadly speaking, faces a tradeoff:
To deploy judges and accept more forgiving, but flexible contract enforcement OR
To deploy regulators and accept overly- aggressively enforcement.
(in other words - Laissez faire or government intervention).

BEST SCENARIO
Establish enforcement reforms that lower the cost of search, stimulate investigation and ensure justice regardless of whether judges or regulators handle the law.

Question 19

“Coase versus the Coasians”

Several articles mention contracts as the solution to corporate governance issues (agency problem specifically). However, as it is argued, they present only a partial solution. State the Coase theorem. Explain why “complete contracts” are impossible. Explain why even complicated and detailed contracts face the problem of enforcement. (5p)

Answer 19

Coase theorem:
when property rights are well defined and transaction costs are zero, market participants’ use of contracts will achieve Pareto efficient outcomes.
§ In such an ideal world, there is no need for the government to interfere through taxes or regulations. If the assumptions are not satisfied, intervention is inevitably needed.
§ The Coasians have deviated from the original Coase theorem. According to them, contractors (e.g. security buyers and sellers) have a vast range of types of contracts to ensure that all possible scenarios can be dealt with by their provisions.
§ Such contracts make most laws and regulations unnecessary.
§ The Coasian judges must be able and willing to read complicated contracts, verify that their provisions have been breached and interpret broad and ambiguous language (Does the manager “abuse minority shareholders” or just following her best judgment? Does he trade on the “inside information” or is simply lucky?)

Ideally, a financier would sign a contract with a manager that specifies division of profits and manager’s actions in all states of the world. But such contracts are infeasible! (The artist should paint a woman naked. But who should be naked - the woman or the artist?)

Typically contracts contain ambiguous and in many ways interpretable language and statements which is why every judge can interpret end enforce the statement by his own judgement.

Question 20

“Coase versus the Coasians”

Authors consider both judge and regulator to enforce laws and contracts. Define the differences between them and specify why and when the regulator could be better. Also, explain in detail why Poland outperformed the Czech Republic in equity market performance, though they started as relatively similar countries. (6p)

Answer 20

REGULATORS
+ Even though judges can be specialized to some extent (e.g. family law), regulators in general possess higher specialization which enables them to enforce more complicated cases and allows for lower search of investigation.
- Established in pursue of certain policies, regulators seek to punish particular violations, as their careers depend on that. Thus, they can engage in more aggressive enforcement relative to the courts at the expense of doing actual justice.

=> Government, broadly speaking, faces a tradeoff:
To deploy judges and accept more forgiving, but flexible contract enforcement OR
To deploy regulators and accept overly- aggressively enforcement.
(in other words - Laissez faire or government intervention).

=> In emerging markets, where the costs of enforcing complicated contracts are high, judges may not be sufficiently motivated to enforce legal rules.
Specialized and aggressive security regulators might then do the trick.

Poland’s financial markets were more successful due to the:
x emphasis on financial and ownership information disclosure
x Disclosure reduces searching cost of intermediaries of getting informed.
x oversight of the intermediaries.

POLAND had interventionist economic policy.
+ Strict broker licensing. “Honest trading” requirement. Licenses could be revoked.
+ Regulator can inspect the books of brokers, able to discipline them without trials.
+ More regulated securities introduction to the market.
+ By tracking the brokers, regulators received the info about the market participants as well.
=> One of the biggest Polish banks at the time, had its license abolished due to favouring its insiders in allocating shares in privatization.

CHECH REPUBLIC had Laissez-faire economic policy.
- Much more pro forma broker licensing, no “honest trading” requirement, easy tests.
- Regulator has no real power to inspect the books of brokers.
=> as a result there was systematic expropriation of minority shareholders in Czech Republic mainly through tunneling – selling company’s assets at below market price to related parties.
Disclosure of such transactions was mandatory in the annual reports only, long after they actually took place. Minority shareholders had virtually no legal recourse to stop them.

Question 21

“Coase versus the Coasians”

In order to identify the circumstances under which the enforcement by two types of adjudicators— judges or regulators—is preferred, authors introduce a theoretical model with four main variables:
c – the cost of undertaking an investigation (search cost);
b – the adjudicator’s payoff from doing justice (following the law);
a – the payoff the adjudicator derives from each punished suspect;
p – the fraction of suspects that are actually guilty.

(i) Describe the incentives judges and regulators face. (2p)
(ii) Which two of the four variables can be affected by the government in the short-run and how? (3p)
(iii) Discuss how Poland and Czech Republic, initially very similar countries, affected the two variables by introducing different regulations of financial markets. What was the outcome of the differences in those financial regulations? (4p)

Answer 21

(i) INCENTIVES
+ seeks to do justice – from this, he derives personal satisfaction and respect from the peers
+ career and/or political pressures (motivated to punish more to show his effort, overly aggressive adjudicator)

(ii)
c) can be reduced by improving accounting systems and disclosure by issuers and intermediaries. The model implies that reductions in the level of c always lead to increases in search. For high levels of c, search may not be achievable.
a) If a = 0, this adjudicator is only interested injustice, and is not motivated by “politics” or short-run career concerns. If a > 0, this adjudicator has a personal interest in finding violations.
The state may be concerned with finding violators of particular rules to achieve its broader political goals, such as fighting drugs or treating unfairly particular ethnic minorities.

(iii) Poland’s financial markets were more successful due to the:
x emphasis on financial and ownership information disclosure
x Disclosure reduces searching cost of intermediaries of getting informed.
x oversight of the intermediaries.

POLAND had interventionist economic policy.
+ Strict broker licensing. “Honest trading” requirement. Licenses could be revoked.
+ Regulator can inspect the books of brokers, able to discipline them without trials.
+ More regulated securities introduction to the market.
+ By tracking the brokers, regulators received the info about the market participants as well.

CHECH REPUBLIC had Laissez-faire economic policy.

• Much more pro forma broker licensing, no “honest trading” requirement, easy tests.
• Regulator has no real power to inspect the books of brokers.

OUTCOMES
=> One of the biggest Polish banks at the time, had its license abolished due to favouring its insiders in allocating shares in privatization.
=> as a result there was systematic expropriation of minority shareholders in Czech Republic mainly through tunneling – selling company’s assets at below market price to related parties.
Disclosure of such transactions was mandatory in the annual reports only, long after they actually took place. Minority shareholders had virtually no legal recourse to stop them.
=> Polish market grew almost sevenfold, while it declined afterwards in Czech Republic.
=> Large number of public firms in Czech Republic were delisted while the number of listed Polish firms grew over time.
=> Number of Polish firms included in IFC Investable index grew from 9 in 1992 to 34 in 1998, compared to an increase from 5 to 13 of Czech stocks.
=> No IPOs in Prague stock exchange, while there were 136 in Warsaw. Almost no equity financing in Czech Republic, while it grew to reach $1bn by 1998 in Poland.
=> Relying on external equity finance, industrial production grew faster in Poland.

Question 22

“Behind the scenes: The Corporate Governance Preferences of Institutional Investors”

Article looks at the interaction between institutional investors and their portfolio companies. The authors argue that the threat of exit can be as effective as the exit itself. Discuss the four factors that make the threat of exit more credible/ effective. (4p)

Answer 22

1) exit threat by other investors for the same reason signals that the issue is significant enough to force numerous exits.

2)

3)

4)

Question 23

“Behind the scenes: The Corporate Governance Preferences of Institutional Investors”

The authors explain that even though liquidity and investment horizon can have both positive and negative relationships with voice intensity, their survey results point to one-way relationships. Explain how liquidity and investment horizon can affect voice intensity both positively and negatively and state the survey results regarding the two determinants. (6p)

Answer 23

LIQUIDITY
- Higher liquidity of shares held encourages investors not to bother with activism and liquidate.
+ On the other hand, higher liquidity makes it easier to sell at increased price that reflects engagement efforts. If I can sell at a higher price already tomorrow, why not be active?
=> The paper indicates negative relationship between liquidity and voice: the more liquid shares institutional investors hold, the less they intervene.

INVESTMENT HORIZON
+ Long-term shareholders might be incentivized to intervene, because they can collect the long-term benefits. Long-term investors might also have more time to gather information for effective intervention.
- It is claimed that hedge funds (short-term mostly) sometimes push for actions that are profitable in the short run, but casing damage in the long run.
=> The paper shows positive relationship between horizon and voice: long-term orientation provides more incentives to monitor and intervene.

Question 24

“Behind the scenes: The Corporate Governance Preferences of Institutional Investors”

According to the authors, what is the role of proxy advisors? What are the two issues that surround the use of proxy advisors? What do the authors find out from the survey regarding the use of proxy advisors and those issues? (5p)

Answer 24

A proxy advisor firm provides consulting services to shareholders on voting in shareholder meetings.

1) recommendations of proxy advisers can be too
standardized and ignoring firm-specific cases (as profit-seeking organizations, are incentivized to
conduct low-cost analyses only)

2) Some proxy advisors serve as corporate governance advisory firms and make recommendations on voting at the same time. Conflict of interest might arise.

Question 25

“Behind the scenes: The Corporate Governance Preferences of Institutional Investors”

What are the two activities that institutional investors conduct when they are unhappy with company’s performance?

What public measures investors can take?

Answer 25

1) Voice – engaging with management to try to initiate changes (discussions, sending letters to management)

2) Exit – leave the firm by selling shares.
(Threat of exit can also serve as a disciplinary action.)

Only when private discussions and negotiations fail to achieve the goal, investors tend to take public measures -
signalling what is happening in the firm to the media.
Aggressive public measures are also extensively used:
- 15% have used legal actions.
- 13% have used public criticism.

Question 26

“A Survey of Corporate Governance”

Name 4 ways how the managers can expropriate firm’s shareholders?

Answer 26

1) Directly take out the money
2) Transfer pricing
3) Empire building
4) Entrenching in the position

Question 27

“Behind the scenes: The Corporate Governance Preferences of Institutional Investors”

What discourages shareholder activism?

Answer 27

1) “free rider” problem – activists would personally incur costs of activism while the benefits would be shared among all shareholders.
=> Higher stake size increases net payoff for activism and limits the “free rider” problem.

2) Inadequate legal rules.
- Diversification requirements for mutual funds can prevent them from taking stakes necessary for effective voice strategy.
- Weak disclosure requirements limits the amount of info that shareholders get providing less opportunities for activism.

3) Investors might be concerned that aggressive engagement might affect their future relations with firms
4) Fund managers might not bother engaging if they are not sufficiently rewarded for activism (compensation problems).

Question 28

“Behind the scenes: The Corporate Governance Preferences of Institutional Investors”

What encourages shareholder activism?

Answer 28

In general, shareholders tend to engage more over long-run strategic issues (e.g. firm’s strategy for overseas markets) than over short-term issues (e.g. low dividends).

Main drivers:
§ Inadequate corporate governance and excessive compensation.
§ Disagreement with a firm’s strategy, specifically large mergers and acquisitions.
§ Contributions to politicians.

Question 29

“The Agency Problems of Institutional Investors”

Why there is growing popularity of index funds (relative to actively managed funds)?

Answer 29

It is mainly driven by the recognition of their:

• low costs (actively managed funds take more fees);
• tax advantages;
• the evidence that they actually outperform actively managed funds.

Question 30

“The Agency Problems of Institutional Investors”

Why are managers of mutual funds reluctant to engage to stewardship?

Answer 30

Stewardship activities, expected from the funds, require substantal costs. Investment managers of index funds bear full costs of stewardship, but capture only a fraction of benefits created.
In contrary, investor without middle man bear full costs but also faces full increase in the value of assets.

=>
Freerider problem occurs because:
- If an index fund spends on stewardship and increases the value of porfolio, this also increases the value of the tracked index, leaving performance relative to it unchanged.
- Rivals following the same index experience the same % increase in value.

Actually their investors are in fact incentivized to switch to their competitors that free ride on others’ expenses, as they offer the same return without higher fees to finance it.

Question 31

“The Agency Problems of Institutional Investors”

What are the superiorities and limits of hedge funds relative to mutual funds when it comes to stewardship and voting?

Answer 31

+ They offer services to sophisticated investors, thus they offer more risky positions, more leverage, more activism.
+ Typical hedge fund manager fee is based on the “2 and 20” scheme. Thus, hedge funds capture a larger value increase compared to the mutual funds.
+ Hedge funds do not offer consulting or money management services for corporations, thus are not afraid of taking positions adverse to corporate managers.
+ hold significant (10%+) stakes in a few companies, capturing much more value from stewardship relative to mutual funds or the index.
+ The returns of activist hedge funds are weakly correlated with each other.

• managers spend on stewardship only when the resulting value increase are high enough to still give investors a reasonable return after higher fees are charged. Opportunities giving smaller returns are ignored.
• need to acquire support from other institutional investors, many of which are not willing to oppose the management.
• Some scholars argue that hedge funds focus on short term returns at the expense of long term value. Mutual funds, on the other hand, prefer long investment horizons. A mismatch of interests? But without mutual fund support, hedge funds are hardly a threat to the corporate management.

Question 32

“The Agency Problems of Institutional Investors”

Modern corporations suffer not from too much shareholder intervention, but rather from too little.
Name 2 possible systematic improvements:

Answer 32

1) Adopting disclosure regulations that would enable beneficial investors identify and assess agency problems themselves (e.g. business ties).
2) Adopting incentive-based compensation for mutual fund managers.

Question 33

“The Agency Problems of Institutional Investors”

What are the agency costs of mutual funds as institutional investors?

Answer 33

1) costs and compensation
( Investment managers of index funds bear full costs of stewardship, but capture only a fraction of benefits created)

2) index tracking
(One way to increase the capacity of stewardship is to increase assets under management. To do it, relative performance matters - but it stays the same relative to the tracked index as well as relative to the rivals following the same index.)

3) active funds
(Most of the active funds are “closet indexers” whose holdings highly overlap with the benchmark index, differing only by under- and over- weighting some stocks.
- any stewardships that move the portfolio towards mimicking the index weights does not enhance performance relative to the index.
- to improve performance relative to the index, increasing the value of an overweight stock actually works)

4) private costs
(Investment managers might bear private costs from taking positions that corporate managers disfavor.)

Question 34

“Extreme Governance: An Analysis of Dual-Class Companies in the United States”

Compare dual class firms with single-class firms by 3 criterions.

Answer 34

DUAL CLASS firms:
- Bigger on median terms
§ More levered, possible due to their reluctance to engage in equity offerings not to lose ownership
§ Older, possibly due to less possibility of being acquired

Question 35

“The bonding hypothesis of takeover defenses: Evidence from IPO firms”

What is the “bonding hypothesis” (examines another path how takeover defenses create value).

Answer 35

• Anti-takeover defenses commit firm to a prearranged business strategy whose reversal is complicated and costly.
• This ensures company’s business partners that the company will not act opportunistically and appropriate them
• this encourages partners to make relation-specific investments.
• This allows the company to gain favorable contract terms with its partners, which increases firm value.

Question 36

“The bonding hypothesis of takeover defenses: Evidence from IPO firms”

Takeover defenses are used in the presence of the following counterparties (3):

What are 4 additional factors enlarging the value of existing business ties thus making firms to take more antitakeover defenses?

Answer 36

1) Large customer - Quasi-rents are more likely to arise when the IPO firm has a dominant relation with a single customer who invests to the specialized distribution lines with its supplier.
2) Dependent supplier - Pemstar invested to locating its specific plants close to IBM’s production facilities. Thus, IBM had a leverage in negotiating lower price for Pemstar’s production, which created quasi-rents appropriable by IBM.
3) Strategic alliance - Alliances between companies tend to be accompanied by costly irreversible investments to fixed assets that give rise to potentially appropriable quasi-rents.

1) Social links.
Social links between the IPO firm’s CEO and the large customer’s CEO make the connection more personal.

2) Pre-IPO relationship length.
Relationships of longer duration tend to involve larger relation-specific investments and thus more quasi-rents at stake.

3) Long-term contracts.
Expected relationship length in the post-IPO period. Similarly, longer expected duration contracts involve greater investments.

4) Percent of customer’s COGS.
What part of large customer’s COGS does the IPO firm sales comprise. Indicates how important the IPO firm is to its customer and thus how prevalent specific investments are in the relationship.

Question 37

“The bonding hypothesis of takeover defenses: Evidence from IPO firms”

What are the effects on IPO firm’s trading partners?

Answer 37

+ potential benefits as the IPO can reduce the firm’s financial constraints and enable larger investments to the relationship

• it puts their business relationship at risk

=> higher potential payoff is associated with higher risk.

Question 38

“The bonding hypothesis of takeover defenses: Evidence from IPO firms”

What is “spillover” effect?

Answer 38

“Spillover” effects: more defenses associate with larger positive returns of its large customer. Large partners of the IPO firm experience negative returns when the IPO firms are acquired.

Question 39

“Corporate Political Contributions and Stock Returns”

What are the factors that determine the ability of a political candidate to benefit the contributing firm?

Answer 39

1) Strength of the relationship.
Longer uninterrupted relations with politicians make them more trustworthy.

2) Ability to help (geography matters).
Officers that hold office in the same state that contributing company resides also have a greater influence on favorable policies.

3) Power of the candidate.
Due to their greater ability to influence policies, important committee members or chairmen raise substantially more money.

Question 40

“Corporate Political Contributions and Stock Returns”

What are the 4 determinants factors of being the best contributor company?

Answer 40

1) size - typically very large with large sales and lots of employees

2) lower returns in previous 3 years - they have been underperforming and hey are trying to increase their returns using politics.
- higher book-to-market ratio
- higher leverage
- lower cash flows and profitability
than their non-contributing counterparts.

3) Companies operating in:
- regulated industries;
- industries involving government purchases
are more likely to exercise political contributions.

Question 41

“On the Foundations of Corporate Social Responsibility”

What does and what does not affect country’s level of CSR?

Answer 41

+ civil law (VS common law) countries
Higher presence of supermajority votes in the civil law countries means that firms are insulated from myopic pressures from shareholders and can more easily engage in long-term-orientated CSR projects.

Does not seem to be a significant determinant of country’s level of CSR:

• cultural values
• religion

Question 42

“On the Foundations of Corporate Social Responsibility”

What are the two channels of firm responsiveness?

Answer 42

1) Consumer channel – shocks trigger changes in consumer demand affecting the market value which forces firms to adjust their CSR.
2) Legal channel – firms in more stakeholder-orientated legal environments tend to be more responsive to shocks.

Question 43

“Active Ownership”

What are the 3 different predictions of how CSR practices affect firm value?

Answer 43

1. CSR practices are based on long-term strategy on company value, consistent with the interests of institutional investors (e.g. pension funds). Firm value should increase!
2. CSR businesses act as a channel to express personal values on behalf of their stakeholders. Delegated philanthropy saves time and information costs of doing charity on one’s own. Firm value should increase!
3. CSR activities are management-initiated, opposed by shareholders, thus revealing agency problems. Milton Friedman: corporation should not do charity with others’ money. Firm value should decrease!

Question 44

“Active Ownership”

What are the 4 channels through which ESG activities affect firm’s value positively?

Answer 44

1) Consumers.
Socially conscious consumers have a greater customer loyalty and are willing to pay premium for ESG-induced product differentiation.

2) Employees.
Firms with higher employee satisfaction due to social engagement (e.g. diversity) tend to outperform the market.

3) Morals. More “virtuous” (having good moral qualities and behaviour) companies attract broader clientele than “sinful” companies (Socially Responsible Investing versus “sin stocks”).

4) Progressiveness.
Successful ESG interventions signal similarly successful future interventions as well as firm’s openness to improvements in other areas.

Question 45

“Active Ownership”

Describe 4 characteristics of ESG targeted firms?

Answer 45

1. Large and mature firms.
   Economies of scale enable such companies to consider investing to ESG practices. Constant public coverage also increases reputational concerns.

2) Institutional ownership.
Other socially conscious investors (e.g. pension funds) increase the chances of collaboration.

3) Underperforming firms. Lower profitability, stock returns, inferior corporate governance – potential room for improvement.

4) Consumer industries.
Consumer-facing and brand-driven firms are more likely to suffer from reputational concerns.

=> Compared to CG activism, ES engagement specifically prefers large-sized, consumer-based firms, having financial capacity to change and caring for reputation.

Question 46

“Active Ownership”

What are the market responses to ESG activism?

Answer 46

=> Mere ESG engagement generates 2.3% abnormal return of firm stock value over the one year (!).

& If engagement is successful, abnormal one-year return increases to 7.1% (!) and flattens after. Most pronounced abnormal returns are entailed by successful activism on corporate governance (8.6%) and climate change issues (10.3%).

=> Successful ESG activism also decreases stock volatility.

=> Compared to CG, ES activism results in higher sales and employee efficiency – consistent with the argument of higher customer base and employee loyalty.

=> No market reaction to unsuccessful engagement is documented.

§ In terms of the effect on stock market values, ESG activism lies between traditional shareholder activism (e.g. nominations of directors) and hedge fund activism (e.g. M&A, spin-off proposals).

Question 47

“Active Ownership”

Are ESG policies beneficial in all cases?

And if ESG policies are so beneficial, why firms might not voluntarily pursue these strategies?

Answer 47

ESG activism increases stakeholder value when engagements are successful and does not destroy value even when activism fails. It’s a win-win lottery.

• Targeted firms have poorer corporate governance limiting the initiation of ESG policies.
• In the absence of active owners, companies might fail to identify ESG opportunities.