CORPORATE GOVERNANCE Flashcards

Question

Behind the Scenes: The Corporate Governance Preferences of Institutional Investors Joseph A. McCathery, Zacharias Sautner, Laura T. Starks What are the potential determinants of voice intensity?

Answer 1

1. Liquidity 2. Investment Horizon 3. Size (that's what she said)

Answer 2

Theory: - 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? Paper: - Indicates negative relationship between liquidity and voice: the more liquid shares institutional investors hold, the less they intervene (simply use exit strategy more)

Answer 3

Theory: + Long-term shareholders might be incentivized to intervene, because they can reap the long-term benefits. Long-term investors might also have more time to gather information for effective intervention. - Contrary, it is claimed that hedge funds (short-term mostly) sometimes push for actions that are profitable in the short run, but detrimental in the long run. + Paper: Positive relationship between horizon and voice: long-term orientation provides more incentives to monitor and intervene.

Answer 4

Theory: Positive relationship - Larger share of company means more absolute payoff for intervention – encourages more activism. Larger funds might also have more resources to engage. Paper: No significant relationship.

Answer 5

“The chances for voice to function effectively… are appreciably strengthened if voice is backed up by the threat of exit.” Managers tend to take discussions with shareholders more seriously in the face of a threat to exit.

Answer 6

1. Some investors might lack the expertise of intervention and thus rely solely on the exit strategy. 2. Investors might face capital gains costs when exiting, which makes the option of voice more attractive.

Answer 7

Complements. Robust positive correlation between the two variables.

Answer 8

Shareholders can collect private information on the fundamental value of a firm, which is then impounded to the price they offer in case of an exit. If a firm is crap, but the public does not know it yet, managers are strongly incentivized to increase firm’s value to avoid exit by informed shareholders. This happens behind the scenes – threat of exit is in fact empirically unobservable, thus survey results are the only data.

Answer 9

1. FREE RIDER PROBLEM - they would personally incur costs of activism while the benefits would be shared among all shareholders. - Higher stake size increases net payoff for activism and hinders the “free rider” problem (when you have more money in one company and others have less, you will benefit more from the company performing better than others) 2. INADEQUATE LEGAL RULES - Diversification requirements for mutual funds - Engagements can lead to legal consequences (when you too loud yelling and do smth bad) - Weak disclosure requirements limits the amount of information that shareholders get providing less opportunities for activism. 3. CONFLICTS OF INTEREST: Investors might be concerned that aggressive engagement might affect their future relations with firms (private costs). 4. Fund managers might not bother engaging if they are NOT SUFFICIENTLY REWARDED for activism (compensation problems).

Answer 10

1. FRAUD 2. INADEQUATE CORPORATE GOVERNANCE, EXCESSIVE COMPENSATION 3. DISAGREEMENT WITH STRATEGY, specifically large mergers and acquisitions. 4. CONTRIBUTIONS TO POLITICIANS 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, underperformance).

Answer 11

Proxy advisory firms provide institutional investors with research, data, and recommendations on management and shareholder proxy proposals. It reduces the costs of being informed by monitoring, collecting information and using professional judgment in recommendations. 60% of respondents use at least one proxy.

Answer 12

1. Proxy advisors ONLY COMPLEMENT INDIVIDUAL JUDGEMENT and do not imply that investors take passive governance role. 2. Recommendations of proxy advisers can be TOO STANDARDIZED and ignoring firm-specific cases. 3. Recommendations are also HARD TO EVALUATE due to LACK OF TRANSPARENCY in their criteria. 4. They are profit-seeking organizations, are INCENTIVIZED TO CONDUCT LOW-COST ANALYSIS 5. Some PROXY ADVISORS serve as CORPORATE GOVERNANCE ADVISORY FIRMS firms and make recommendations on voting at the SAME TIME. CONFLICT OF INTEREST might arise.

Answer 13

Socially responsible investing that seeks to deliver social as well as financial benefits, has attracted increasing attention. $59tn assets (in 2015) are estimated to be managed by companies incorporating environmental, social and governance (ESG) concerns in their decisions. While traditional activism of mutual and hedge funds focuses on issues related to shareholders only, ESG activism advocates for the interest of a broader range of stakeholders (e.g. employees, customers, creditors). However, there is a general ambiguity surrounding the most basic principles of ESG activism: what companies are targeted, what determines its success, how does it affect firm performance

Answer 14

Environmental engagements (E) - climate change, water issues. Social concerns (S) - human rights, public health and labor standards. Governance (G) - audit and control, executive compensation

Answer 15

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!

Answer 16

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” companies attract broader clientele than “sinful” companies. 4. PROGRESSIVENESS: Successful ESG interventions signal similarly successful future interventions as well as firm’s openness to improvements in other areas.

Answer 17

1. RAISING AWARENESS – warning companies about certain ESG issues. 2. REQUEST FOR CHANGE – specific changes are asked (more strict step).

Answer 18

1. Managers doubt the value of engaging in costly project to potentially benefit non-shareholders. 2. ESG engagement is less aggressive compared to hedge funds’ activism. Engagements on environmental and social issues have considerably lower success rate (13.1%) than on corporate governance (24.2%). CG success rate still lags far behind hedge funds’ track record.

Answer 19

1. There is successful prior engagement with the same firm. | 2. Other shareholders collaborate

Answer 20

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. UNDER PERFORMING FIRMS. Lower profitability, stock returns, inferior corporate governance – potential room for improvement. 4. CONSUMER INDUSTRIES. Consumer-facing and brand-driven firms are more likely succumb to reputational concerns (e.g. Nike).

Answer 21

Compared to CG activism, ES engagement specifically prefers large sized, consumer-based firms, having financial capacity to change and caring for reputation. Collaboration with other shareholders is more important than the stake size.

Answer 22

1. Mere ESG engagement generates 2.3% abnormal RETURN of firm stock value. If engagement is successful, abnormal one-year return increases to 7.1% and flattens after. 3. Successful ESG activism also DECREASES stock VOLATILITY (the firm becomes less risky). 4. There is NO REACTION market reaction AFTER UNSUCCESSFUL engagement. (win-win situation) 5. Effect on stock market values: ESG activism lies between traditional shareholder activism and hedge fund activism. Side note: ESG improvements in the target firms are not a result of superior future performance (as argued before)

Answer 23

1. Abnormal returns are highest on corporate governance (8.6%) and climate change issue (10.3%) engagements. 2. Compared to CG, ES (environmental and social) activism results in higher sales and employee efficiency – consistent with the argument of higher customer base and employee loyalty.

Answer 24

1. Targeted firms have poorer corporate governance hindering the initiation of ESG policies. 2. In the absence of active owners, companies might fail to identify ESG opportunities.

Answer 25

1. ESG activism increases stakeholder value when engagements are successful and does not destroy value even when activism fails. It’s a win-win lottery. 2. Responsible investment initiatives are less confrontational, more collaborative and benefits society at large.

Answer 26

Widely held corporations with dispersed ownership among small shareholders have been prevalent in the US since early 20th century. Times are changing: institutional investors saw a rise in the recent decades (from 6.1% of US corporate equity in 1950 to 63% in 2016). By aggregating the assets of investors, institutional investors hold substantial stakes in corporations to have non-negligible effect when voting.

Answer 27

Engagement with public companies to promote corporate governance practices that are consistent with encouraging long-term value creation for shareholders in the company. 1. Voting in shareholder meetings (and being informed when voting) 2. Monitoring corporate managers 3. Engaging with the management (using voice and exit) Stewardship activities, expected from the funds, require substantial costs. Performance of these duties is under the discretion of the investment manager. Is he/she fully reliable?

Answer 28

Investment funds - Investment funds pool together the assets of many individuals and invest them in a diversified portfolio of securities. 1. Index funds (Passive) 2. Active funds (most of them are “closet indexers”) 3. Hedge funds (very active)

Answer 29

1. Recognition of their low costs 2. Tax advantages 3. Evidence that they actually outperform actively managed funds.

Answer 30

1. Costs and compensation 2. Index Tracking 3. Active Funds 4. Private costs

Answer 31

Investment managers of index funds bear full costs of stewardship, but capture only a fraction (as low as 0.12%) of benefits created, because compensation is based on fixed % of assets under management. Thus, investment manager only undertakes a stewardship if its cost is less than its payoff for her, still based on a fraction of increased value of assets.

Answer 32

1. Relative to the index: If an index fund spends on stewardship and increases the value of a portfolio this also increases the value of the tracked index, leaving performance relative to it unchanged. 2. Relative to the the rivals: Rivals following the same index experience the same % increase in value.

Answer 33

Index funds engaging in stewardship do not improve relative performance to attract more assets (because they improve the whole index that others have invested in). 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. Example:Index fund Vanguard employs only about 15 staff for voting and stewardship at its 13,000 portolio companies.

Answer 34

Most of the active funds are “closet indexers” (i.e. they are not so active) whose holdings highly overlap with the benchmark index, differing only by under- and over- weighting some stocks. They also capture only a small fraction of benefits arising from stewardship activities. If stewardship increases the value of an underweight company, index (and funds that track it) benefits more than the active fund, even decreasing its performance relative to the index. On the contrary, to improve performance relative to the index, increasing the value of an overweight stock actually works. These relationships are more complex for mutual fund families that organize several funds under one management where multidimensional decision-making takes place, i.e. which funds would be favoured by certain actions.

Answer 35

Investment managers often run both investment fund and investment services (e.g. cash management, short and long term investments) firms Investment managers might bear additional private costs (e.g. losing revenue, reputation) from taking positions that corporate managers disfavor. If stewardship opposes corporate management, investment managers are only willing to undertake a stewardship if the fraction-based payoff is larger than stewardship costs plus private costs. Investment funds with more business ties with corporations are in fact documented to make more pro-management decisions and avoid aggressive stewardship.

Answer 36

Institutional investors might not act in the best interest of their clients – institutional investors might not engage in stewardship activities or might not invest enough in stewardship activities because they have no incentives to do so. Agency problems of institutional investors prevent the full realization of the potential benefits of the increased concentration of shareholders.

Answer 37

1. 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. 2. Hedge funds do not offer consulting or money management services for corporations, thus are not afraid of taking positions adverse to corporate managers- no conflict of interests. 3. Hedge funds hold significant (10%+) stakes in a few companies, capturing much more value from stewardship activities relative to mutual funds or the index. 4. Hedge funds devote more person-per-hour and have representatives on the board of directors in each company in their portfolio 5. The returns of activist hedge funds are weakly correlated with each other. Every slight performance difference signals fund superiority.

Answer 38

Hedge fund managers spend on stewardship only when the resulting value increase is high enough to still give investors a reasonable return after higher fees are charged. Opportunities giving smaller returns are ignored. To win proxy fights, hedge funds need to acquire support from other institutional investors, many of which suffer 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. Without mutual fund support, hedge funds are hardly a threat to the corporate management.

Answer 39

Investment managers have incentives to spend less on stewardship and side with managers than would be optimal for beneficial investors. The rise of index funds, while having seen as a positive development, raise serious costs for corporate governance. Modern corporations suffer not from too much shareholder intervention, but rather from too little.

Answer 40

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

Answer 41

If protection of shareholder rights is STRONG –> PBOC is LOW -> shareholders can expect to get a proper financial return If protection of shareholder rights is WEAK –> PBOC is HIGH -> shareholders will get less money

Answer 42

Anti-takeover provisions (aka takeover defenses) are actions taken by a firm's management to prevent unwanted takeovers. (Unwanted takeover - acquisition of one company by another that is accomplished by: - -going directly to the company's shareholders OR; - -fighting to replace management to put in a new management that will be more likely to get the acquisition approved. Key characteristic of an unwanted takeover - target company's management does not want the deal to go through, so it will defend against takeovers by using several strategies) MORE takeover defense means LESS rights for the shareholders.

Answer 43

Higher antitakeover defenses---> - --> managers who run firms inefficiently cannot be thrown out - --> decrease in firm’s value through lower operating performance.

Answer 44

1. Charter amendments 2. Golden parachute 3. Poison pills 4. Pac man defense

Answer 45

Charter amendment OR Shark Repellent (anti-takeover technique) Imposing conditions in a firm's charter ("a legal document that formally establishes a corporate entity") on control transfer. Ex: requiring over 2/3 shareholder vote to approve a merger/acquisition. (how to remember the name: "when a shark attacks, shark repellent can send the shark away from its place of attack" - so charter amendment a company's way on HOW to send away the sharks)

Answer 46

Golden parachute: Substantial benefits (compensation) that is guaranteed to a firm’s senior management if the firm is taken over and the managers are let go.

Answer 47

Poison pills: Strategy to make the company's stocks seem less attractive to the acquirer. Accomplished by making the company's stock more costly to acquire. Ex1: Allowing existing shareholders to buy more stock at a discount which increases the number of shares that the acquirer will have to buy. Ex2: Creating employee stock option plan that shows up only when the company is taken over which makes it more difficult to retain key employees after a takeover.

Answer 48

Pac-man defense: Company trying to acquire the acquirer in an attempt to scare off them (Tinder buying Bumble, Bumble threatening to buy Tinder - not irl) During the takeover phase, the acquirer may begin a large-scale purchase of the target company’s stocks to gain control of the target company. As a counter-strategy, the target company may begin buying back its shares and purchasing shares of the acquiring company.

Answer 49

The authors argue that the existence of dual-class stocks in a company ALSO can be an anti-takeover strategy (it has apparently been forgotten). Authors look at how being dual-class company in the US influences the firm's value. Background info: Dual-class company has two types of shares: 1. Superior shares with more votes per share 2. Inferior class, with one vote per share ``` Superior class of shares is usually owned by company insiders which provide insiders with a majority of votes. Thus, insiders of dual-class firms have effective control over all corporate decisions which makes them virtually immune to hostile takeovers. Additionally, inferior shareholders have less control and thus can be more easily expropriated, leading to a worse performance of the firm. ```

Answer 50

1. The insiders (the ones who hold superior shares) of own a majority of the voting rights (~60%) 2. The insiders own a minority of the cash flow rights (~40%), meaning that they bear considerably smaller financial consequences for their decisions. 3. Dual-class firms are BIGGER than one-class firms on median terms of firm value 4. Dual-class firms are MORE LEVERED, possibly due to their reluctance to engage in equity offerings not to lose ownership (If I issue more stock, my control gets weaker) 5. Dual-class firms are OLDER, possibly due to less possibility of being acquired.

Answer 51

1. Name (A company named after a founder indicates a more “personal” stake involved); 2. Media (Control of a media company provides opportunities for self-advertising, manipulating the public opinion); 3. Activity of the founder (PBOC and also dual-class structure is more likely if the firm is young and the founder is still active); 4. Firms in the area & Sales of the area (the less firms there are in firm’s area, the more likely the firm is a major employer in town which entails private benefits for insiders with dual-class shares - additionally, firms with an important local presence may use dual-class status as a promise to local authorities that the firm will resist takeovers in order to honor implicit contracts with local governments and other stakeholders).

Answer 52

Endogeneity/Loop of Causality– it is not only that ownership structure determines firm's value, but it can also be that the firm's value influences the ownership structure

Answer 53

Nevertheless, the paper finds that: 1. Firm's value is positively associated with insiders’ cash-flow rights. (insiders have more cash flow rights - (possibly) more incentivized to make good decisions because of monetary risk - firm's performance, and, thus, value increases) 2. Firm value is negatively associated with insider voting rights (more insider voting rights decreases the firm's value) 3. Firm value is negatively associated with the wedge between the two (insider voting rights – insider cash flow rights). - The more imbalanced they are, the more negative firm's value is.

Answer 54

1. If majority owner deems establishing PBOC more important that maintaining firm value, he will rationally choose to sacrifice some of firm value to maintain PBOC. 2. PBOC from controlling a newspaper, news agency or brand identity can outweigh financial losses of the firm.

Answer 55

Morningstar Sustainability Ratings show the sustainability level of funds. Funds are ranked depending their holdings of sustainable stocks. The result in website is portrayed in scale of "five-globes": Top 10% - Most Sustainable - 5 globes; Between Top 10% and 32.5% - Above AVG - 4 globes; Between Top 32.5% and 67.5% - AVG - 3 globes; Between 67.5% and 90% - Below AVG - 2 globes; Worst 10% - Least Sustainable - 1 Globe

Answer 56

If a fund is generally viewed as more desirable after its rating becomes public, money will flow into it and it will grow. If it is viewed as less desirable, we will see money flow out of it and it will shrink.

Answer 57

Yes, they do. Investors mostly look at GLOBE RATINGS rather than pure measure of percentile or sustainability score (investors often focus on discrete rather than continuous measures) Investors focus on EXTREME outcomes - 1 globe and 5 globe rating funds see the largest impact Prior to the rating publication, funds received similar levels of flows, so there were no fundamental differences.

Answer 58

1. they face institutional constraints; 2. they have rational performance expectations; 3. they have irrational expectations and non-quantifiable motives The authors find evidence consistent with nonpecuniary (non-quantifiable, non-monetary) motives of being an important driver when choosing to invest in sustainable stocks.

Answer 59

Reason: Institutional investors are often OBLIGED to hold high sustainability stocks or constrained not to hold low sustainability stocks Discussion in article: If institutional constraints are the reason for the increased fund flows in high sustainability funds, we should see more fund flows from institutional share classes than from non-institutional share classes; however, there is NO difference between the fund flows.

Answer 60

Yes! If investors believe sustainable funds will outperform the market, funds will flow to high sustainable funds Real life: Evidence is more consistent with an INVERSE relation or NO relation between globe ratings and returns rather than the positive relation (high sustainable ratings are not necessarily associated with better future performance) Therefore, investors have irrational expectations?

Answer 61

YES! Investors might assume that a high sustainability rating would lead to high future fund returns OR they simply had a non-monetary (social) preference for holding more sustainable mutual funds Authors run an experiment and find evidence on irrational expectations: Environmentally and socially conscious participants (therefore, people with non-quantifiable goals) when making their investment decisions, invest more money in 5-globe funds and less money in 1-globe funds, comparing with those not environmentally and socially conscious.

Answer 62

They look at institutional investors. Additionally, firm-level environmental and social performance measures are created (covering such areas as CO2 emissions, renewable energy use, human rights violations, and employment quality) from several E&S data providers, as well as these providers’ E&S scores.

Answer 63

Institutional investors' exposure to social norms is non-negligible, as they need to network and raise capital locally and they are (at least to some extent) mindful of local E&S social norms. The tests in the article show that, for independent institutional investors, no impact is evident when considering the firm’s E&S performance if the investor is from a country where E&S social norms are relatively weak (such as the US). This inverse is applicable for countries with high social norms (such as the Netherlands). Only European institutional investors were shown to impact firms’ E&S performance. Pension plans consistently influence firms to strengthen E&S performance no matter the country they’re in.

Answer 64

1. An investor becomes a signatory to the UN Principles for Responsible Investment. Being a signatory requires that investors incorporate ESG issues into their investment analysis and decision making 2. The firm has greater scope for E&S improvement. Greater effects were expected in the firms with low initial E&S performance.

Answer 65

1. Exit and selection (use negative screening to exclude poor E&S performers or positive screening to buy only firms above certain E&S thresholds). Authors find that this method does not account for broad, large-scale changes. 2.Voice (voicing their concerns to the management). As exit and selection has not been prevalent, the authors state their assumption that voice will prevail as the more important mechanism for demanding change.

Answer 66

1. Social returns (but only when these investors are from countries where social norms reveal a greater demand for E&S performance) 2. Financial returns (but strong enough social norms can overcome market pressures to focus on these)

Answer 67

Stakeholderism: focusing stakeholder interests – essential for maximizing shareholder values, others believe stakeholders should be the focus regardless of shareholder value.

Answer 68

Research: What drove firms to decisively respond to the invasion of Ukraine? (support Ukraine by hindering Russia)? Why is there a need to review it? – Firms that withdraw from Russia are rewarded and those that remain are punished (in Academia and public).

Answer 69

Hypothesis 1: Ethical judgment, even at the cost of shareholders. Hypothesis 2: (Small) exposure to Russia and reputational risks.

Answer 70

1. Corporate leaders tend to prioritize social objectives when they believe it maximizes returns, and not obtaining the said social objectives. (JP Morgan said they withdrew and continued trading debt + Corporate leaders referred to their decision of leaving or staying in Russia as supportive of stakeholders regardless of what they actually did) 2. Twitter-based “virality” played an important role in companies cutting ties with Russia. Stakeholder pressure is an effective instrument to promote responsible management (but only as a complement). 3. Smaller companies are left free to operate without the important managerial constraint from stakeholder pressure. (important because small companies can be just as harmful as big companies if they conduct a significant portion of business in Russia) Taken together, the evidence presented in this paper supports the view that even though private ordering can contribute to more socially responsible management, external interventions such as legislation, regulation, and policy design are often critical to protecting stakeholder interests.

Answer 71

Influencing factors are -legal system - economic development (weak correlation). The correlation is negative between income and corporate control, and it is pronounced only for large corporations (top 10%) - shareholder protection (possibility to take legal action against managers who abuse their position) is linked with dispersed ownership. - labor legislation (positively correlated to corporate control).

Answer 72

1. French civil law countries Most ownership concentration. 2. German and Scandinavian civil-law countries German civil-law countries take 2nd place and then come Scandinavian civil-law countries. All 3 show similar patterns in ownership concentration. 3. Common-law countries Lowest ownership concentration.