CG2016Q5 Flashcards
What are agency costs?
Costs that occur to owner due to conflicts of interests with managers
- Monitoring expenditure
- Bonding expenditure by agents (incentives)
- Residual costs (value loss for wrong decisions)
What are the control mechanisms for agency costs?
- Executive compensations
- Board of directors
- Large investors
- Takeovers
- Auditors, ratings etc.
What are the agency benefits and costs?
What are the three types of agency problems?
- Owner vs. manager (type 1)
- Majority vs. minority owners (type 2)
- Shareholder vs. stakeholder (type 3)
What is the owner-manager problem?
When agent doesn’t act in the interest of the principal
What is the majority and minority investor problem?
When there are conflicting interests between the minority investors and majority investors.
What is the shareholder and stakeholder problem?
When shareholders make decisions in their own interest (fx short term profit, resulting in worse long term results)
What is the Rule of man?
Always seek to maximize own benefits and personal utility. Moral responsibilities to act in someone else’s interest are second priority.
What is adverse selection?
When there is asymmetric information, so one part knows more than the other part. Example with ‘Lemons’, seller knows more about the condition of a car than the buyer.
What is moral hazard?
When one part takes more risk, than he would otherwise have done, because he does not bear the same risk.
Solution is for managers to share some of the same risks as owners.
What are the 5 things Agency theory consists of?
- Rule of man
- Interest divergence
- Agency problems
- Agency costs
- Control mechanisms
What is Stewardship Theory?
The theory that managers, left on their own, will act as responsible stewards of the assets they control. Alternative to the agency theory.
What is the difference between agency and stewardship theory?
What are the two ways to view the firm?
- Firm oriented view
- Owner oriented view
What are the assumptions in agency theory?
- separation between principal and agent
- conflicting interests
- rationality
- asymmetric information
- uncertainty
- risk aversion
What is ownership?
A set of rights and obligations concerning assets such as:
- user rights
- profit rights
- disposal rights
- control rights
However, it also includes some responsibility! fx if you own a gun, it is your responsibility that the neighbour’s children cannot find it easily.
What are active and passive owners?
Passive: never interfere in the running of the firm
Active: interfere in the running of the firm, and typically a seat in the board
What is under-monitoring?
When many small owners, hence, no incentives to take the burden of monitoring management.
What is self-dealing?
Managers use private information to extract from the firm through transactions
E.g. letting another company they own buy cheap from the company they run.
What agency problem does dispersed ownership relate to?
Agency type 1 problem (owner vs. manager)
Manager has extensive power due to collective action and free rider problems
What agency problem does concentrated ownership relate to?
Agency type 2 problem (majority vs. minority owners)
Owner is more powerful, and has more incentive to monitor, however, his portfolio risk is greater.
Is it better to have a concentrated or dispersed ownership structure?
Many researchers find a U-shaped link between the two. So something somewhat in the middle is optimale.
When is a firm’s structure called a pyramid?
When there is at least one publicly listed firm between the ultimate owner and the firm
What is cross-holdings?
When a publicly traded company does have share of its (ultimate) owner.
What is the advantage of government as owner?
Easier to get money
What are the 6 types of owners?
- Founders & families
- The state (government)
- Institutional investors
- Industrial companies
- Banks
- Foundations
What is a blockholder?
An entity that holds at least x% of equity in a company
Who is the first layer owner?
Shareholders who directly hold the shares
Who is the ultimate owner?
Person or entity who ultimately control the voting rights
What are the reasons for evolving the ownership?
- Financing growth
- Risk diversification
- Privatization
- Best-owner problem
What kind of businesses do governments usually own?
Infrastructure firms such as transportation and telecommunication
Or when certain regimes are in power, e.g. China
What are the types of institutional investors?
- Pension funds
- Insurance companies
- Mutual funds
- Public Pension Reserve Funds
What are institutional investors?
Financial intermediaries specialized in investing money which they collect from other investors
What are mutual funds?
Funds you can invest in that was a variety of mixes of bonds, stocks, cash etc.
What is private equity?
A firm that takes over bad companies to rebuild them and sell them for a higher price
What is a director?
Member of the board of directors
What is an executive director?
Director that serves as an executive of the firm
What is an inside director?
Director that is employed by the company
What is the role of the management?
Initiation and implementation
I.e. they take initiative to ideas and implement them.
What is the role of the board?
Ratification and monitoring
I.e. they accept management initiations and thereafter monitor them when implemented.
What are the views on CSR?
- win-win
- Delegated philanthropy
- Insider initiative
What are the types of law?
- common law (US/UK)
- Civil law (EU)
What is delegated philanthropy?
engaging in CSR on behalf of customers
What is the trade off between base pay and incentive pay?
Too much incentive pay will make the agent take too much risk, as he cannot become rich otherwise.
What is the vega and delta effect?
A sharp decline in stock price:
- Delta: reduces the sensitivity of pay to performance
- Vega: increases the sensitivity of pay to stock-return volatility
What is the definition of Corporate Governance?
‘the system by which companies are directed and controlled’
What is the basic governance problem?
Agency problem
What is the idea behind agency theory?
That people will respond rationally to incentives under asymmetric information
When does an agency problem occur?
Whenever someone (agent) does something for somebody (principal) else.
What are examples of agency relationships?
- Boss and employee
- House seller and real estate agent
- Citizens and government
- Patient and doctor
However, the relationship between a buyer and seller is not regarded as an agency relationship.
What is informal governance?
The 90% of the iceberg: social norms, ethics, reputation, codes and other soft mechanisms.
What characterises Investor Ownership?
- Easy access to capital
- Low risk aversion
- Long time horizon
- Arm’s length relationships
- Performance measured in financial success
- Empirical evidence: positive effect of investor ownership on company performance
What characterises Family Ownership?
- Double role of family
- Long-term commitment
- Relatively risk-averse
- Expropriation (running company at expense of minority shareholders)
- Stock market reacts positively on the sudden death of a major ownership
- First generations over perform, and next generations perform average or below
- Capital-rationed
What characterises Bank Ownership?
- Illegal in the US, and avoided in UK
- Important in the German model (Hausbanks)
- May have privileged access to capital, information and other services
- Positive performance effect of bank ownership among West German firms
- Less likely to be credit-rationed
What characterises Corporate Ownership?
- Mostly seen in Japan (Keiretsu), France (cross-holding, and Sweden (business groups)
- Integration of value chain (vertically)
- Internalization of transactions
- May facilitate knowledge transfer
- Loss of flexibility
- Risk of deficient mutual monitoring
- Worse export performance
What characterises Government Ownership?
- Internalize relationship between company and government (institutional alternative to regulation)
- Special attention to political goals
- Non-profit maximizing behaviour
- Expected to correct market failures
- Low performers in terms of conventional performance measures
- Relatively wealthy
What is the Board of Directors and what does it do?
The board of directors is an intermediary between the firm’s shareholders and its top management team, and is elected by shareholders.
Role:
- Final arbiter of all major decisions
- Decision-making rights over the firm’s assets
- Evaluating the company performance
- Hiring and firing CEO and other top management
- Ensure ideal business strategy
- Decide on a number of issues, fx auditing, compensation or nomination of new board members.
What is the difference between executive and non-executive directors?
Executive: board members who work in the firm (inside directors)
Non-executive: board members who don’t work in the firm (outside directors)
What is CEO duality?
When the CEO is also a chairman (typical in the US)
What is the purpose of a Board of Directors?
Two things: principal-agent theory and incomplete contracts.
The BoD is the intermediary between the shareholders and CEO, and deal with the issues of incomplete contracts and the cost of asymmetric information between shareholders and the CEO.
How is work between board and management divided?
Management: initiation and implementation
Board: ratification and monitoring
However, for a dual-system, such as in Germany, the supervisory board deals with the ratification/monitoring, and the management board deals with the initiation/implementation.
What are the three C’s - the three different roles at the board?
- Control role: monitoring function stressed by agency theory
- Consulting role: the service function stressed by stewardship and resource dependence theory
- Contact role: the networking function stressed by resource dependence theory
What is the theory of friendly boards?
Cooperate rather than control the CEO
What is the resource dependence theory?
The theory that directors can contribute resources such as advis, access to outside information, preferential access to external resources, and legitimacy.
Fx a lawyer in the board, or a finance guy.
May beneficial in smaller companies, where the control role is not as important, or in communistic countries such as China, where political connections are important, where it would be beneficial to have a political person in the board.
When is a board member dependent according to UK governance code?
- Has been employee within the last 5 years
- Material relationship within the last 3 years
- Received remuneration from company beside director’s fee
- Participates in company’s share option
- Close family-ties
- Cross-directorships
- Significant shareholder
- Served for more than 9 years
What is the business judgement rule?
A rule in US: that the court will not review the business decisions of director who performed their duties in good faith, with care and loyalty.
What are the directors’ duties?
- Fiduciary duty
- Duty of loyalty
- Duty of fair dealing
- Duty of care
What does the UK Companies Act of 2006 say about directors’ duties?
- §171: must act within their powers provided in the company’s articles of association
- §172: promote the success of the company
- §173: independent judgment
- §174: exercise reasonable care
- §175: avoid conflicts of interests
- §176: not to accept benefits from third parties
- §177: declare any interest in a proposed transaction
What is the senior independent director also called ‘lead director’?
A spokesperson for the other non-executives
How is the agenda normally for a board meeting?
- Quorum/approval of agenda
- Approval/signature of minutes
- Messages (non-decision/consent items)
- Committee reports
- Current financial status
- Proposals
- Briefings
- Any other business
How is the board work related to the corporate life cycle?
- Start-up: board is mainly involved in enhancing the firm’s legitimacy
- Growth: advisory role of the board is primary
- Crisis: control is the most important role
What are the findings on boards monitoring?
Monitor more if perfomance decreases
Monitor less if performance increases
Duality reduces the level of monitoring
What curve is the board work said to follow?
A bell-shaped relationship between board involvement and company performance is proposed.
Board involvement adds value up to a point after which it may become excessive and do more harm than good.
What are the 4 different boards focusing on board and CEO power?
- Caretaker board: low CEO, low board
- Statutory board: high CEO, low board
- Proactive board: low CEO, high board (most efficient)
- Participative board: high CEO, high board
High board power is said to be most efficient in general
What are the two theories of executive compensation?
- Optimal contracting theory
- Managerial power theory
What is the optimal contracting theory?
That the executive compensation is determined by the market, and that executive compensation is given to make the CEO choose the optimal action, i.e. focus on firm performance, rather than doing moral hazard - because it leads to greater personal wealth.
What is managerial power theory?
- Contrasts with optimal contracting theory.
- That executive compensation is not the outcome of arm-lengths contracting
- Executive pay is excessive
- Extra pay is not in shareholders’ interests
- CEO pay is not the solution to corporate governance, but rather a part of the problem itself.
What is the economic objective of executive compensation?
To align the interests of the CEO and the firm’s owners
What are the forms of CEO moral hazard?
- quiet life (easy-to-manage tasks)
- avoid risky project (risk-averse CEO)
- engaging in self-interested empire building (e.g. via M&A)
- excessive use of company perks
What does the executive compensation typically exist of?
4 broad elements:
- annual salary
- annual bonus
- equity (e.g. stocks or options)
- other benefits (e.g. retirement pay and perks)
Why does stock options lead to more incentive for the CEO to make the stock rise?
Because there is a convex pay-off, a 10% increase in the stock results in a more than 10% increase in the option’s value.
What is delta?
The change in the call value of the option with respect to the underlying price of the asset.
Delta is between 1.0 and 0.0, and a higher delta means a higher change in the call value of the option. Let’s say that the underlying assets are trading at 100, and delta is 0,5, and the call value of the options is $10. If the underlying asset increases by $1, then the underlying asset will increase by $0.5, i.e. to $10.5, which is a 5% increase, compared to the underlying asset that increased by only 1%. Hence, stock options have a convex pay-off curve.
What is vega?
The derivative of the option value with respect to the volatility of the underlying asset.
It is mathematically true that the percentage change in volatility is higher than the percentage change in the value of the option.
What are some empirical evidences on executive compensation?
- CEO cash compensation and total compensation varies positively with firm revenues
- Annual rate of growth in pay is around 10%
- Growth in market value is also around 10%
- So CEO pay is fixed around the pay to market value ratio
- The larger the firm, the larger a fraction of compensation is ‘at risk’
- Positive relation between pay and perfomance on average
- Weak boards leads to high CEO salary
- CEO pay has grown while board power has increased (contradicts the managerial power theory)
What is the bedrock of US corporate governance?
Strong property rights and protection of investor rights
What characterizes US corporate governance?
- Unitary board
- CEO is often chairman (duality)
- Large firms means large boards
- High ethical standard
- Non-executive board members control the committees
- 80% non-executive members of board
- Mostly only CEO and CFO members of board
- Duality
- Many small shareholders
- Institutional owners
- High salary, and a higher share paid with stocks
- Takeovers are common
- Shareholder value maximization
- Sarbanes-Oxley and Dodd-Frank
- Anglo-Saxon
What are the most important board functions?
- Identify and select CEO
- Recruit and retain candidates for the board
- Evaluate the CEO in relation to; strategy, operations, and financing
- Make sure the company comply with laws and regulations
What characterizes UK corporate governance?
- Unitary board (much similar to US board)
- Audit, remuneration, and a governance committee
- CEO does not serve as chairman
- Only 50% non-executive members of board
- Less independent board members than US
- Strong property rights
- Protection of investors
- High World Bank strength of rights
- Focus on stakeholders
- Active takeover market (constraining managerial opportunism)
- ‘Comply or explain’ -> follow the code of conduct, and if not, explain why
- UK market is less bureaucratic and cumbersome than US
- Ownership is less dispersed than US (but still dispersed)
- A bit stronger owners and weaker managers than US
- Executive pays are lower than US
- Less takeover defence
- Less major financial scandals
- Cadburry Committee
- Anglo-Saxon
How is the US corporate governance compared to the UK and Germany?
How is the ownership structure in US?
- Many small shareholders
- Each shareholder own a tiny fraction of the common stocks
- i.e. weak owners and strong managers (moral hazard and collective action)
How can dispersed shareholders exercise power?
- Sell shares
- Exercise ‘voice’
How are shareholders different?
- They differ in objectives and preferences
- They differ in scale and size of holding
- They differ in type (fx individuals, institutional etc.)
What is the relationship between Tobin’s Q and institutional investors?
Positive. More institutional investors mean higher Q
What is the effect of institutional investors on R&D costs?
Positive. Companies are less likely to cut R&D costs to reverse declining earnings, if they have a large share of institutional investors.
What are the main empirical findings on institutional investors?
- Significant future improvements in shareholder rights consistent with shareholder activism
- Impedes managerial myopic behaviour
- Firms are less likely to cut R&D costs to reverse declining earnings, if they have a large share of institutional investors.
- Positive impact on firms’ value
- Less executive compensation, and more performance based compensation
- Board are typically not very competent, but does not tend to underperform
- Usually not very well governed
What is the problem with indexing a market?
You have to buy a lot of different shares, and cannot monitor each company. Also, you will have to buy up in companies who appreciates, which can lead to a bubble, as the stock price will appreciate further as you buy up.
Why does institutional investor prefer to not have a too large share of ownership?
Because it is harder to get rid of the stock, and they can be accused for insider trading, even though they do not.
What is the rationale for your level of activism?
The costs of being an active investor compared to the return you get.
What do institutional investors do, if they cannot get their ‘voice’ heard?
Either they sell their shares, or they buy more, in order to get more influence.
Why does banks exists?
As a solution to moral hazard and adverse selection
Moral hazard: borrows may take risks, which will benefit them if things go well, while the bank losses if things go wrong.
Adverse selection: hidden knowledge and action
In what ways do banks exercise governance?
- as lenders
- as advisors
- as owners
- as trustees
- as board member
How is German corporate governance?
- Greater role of bank
- Relationships with banks
- Two-tier board system (mandatory)
- Supervisory board (non-executives) and management board (executives)
- Bank has considerable power
- Bank is typically present on supervisory board
- Banks have significant access to information
- Few hostile takeovers
- Concentrated ownership
- Employee representation (employees can elect up to 50% of the board when more than 2000 employees)
- Less risk-taking (banks and employees do not benefit when things go well)
How does German banks dominate German corporate governance?
- Through ownership,
- Ownership representation
- Board membership
- Lending relationships
Where is the German corporate governance heading?
Towards the market model
Why is the possibility of a takeover important?
Agency theory: incentive for the CEO to perform good, as the company will be taken over if he performs bad, in order to increase the value of the firm. If the firms is taken over, the CEO will most often be replaced. So it is a form of corporate control.
What is the mandatory bid rule in Germany?
A rule that obliges buyers to offer all shareholders the same bid when they acquire a block of shares
How is a two-tier board different from a one-tier?
- More conservative
- Tend to reject more projects
- Supervisory board is superior to management board
How is the Japanese corporate governance characterized?
- relational governance
- on-going relationships
- trust and reputation
- long-term contracts
- employees and consumers are loyal
What are the two forms of keiretsu?
Horizontal: large corporation that owns different business units across different sectors
Vertical: fully integrated value chain
What is the stakeholder view of corporate governance?
To maximize value creation for all stakeholders
What are the three theories of nonprofits?
- Altruism model
- Worker cooperative model
- Non-contractible quality model
What is the idea of the non-contractible quality model?
That firms do not behave opportunistically and reduce the quality of a product on purpose in a way that cannot be detected by the buyer.
What are dual class shares?
Different classes of shares with different voting rights, but same cash-flow rights.
What agency problem is related to pyramid owning structure?
Agency Type II problem - majority vs. minority.
A family can appoint 100% of the board members, if they own 51% of a company, that owns 51% in another, which further owns 51% in another.
