Guiding Seminar 3 Flashcards
What is corporate governance? (A Survey of Corporate Governance)
▪ Corporate governance deals with the ways in which suppliers of finance to corporations can assure themselves of getting a return on their investment. Stems from the separation of ownership.
▪ The fundamental problem of corporate governance is how to assure financiers that they get a return on their financial investment?
▪ CG mechanisms are economic and legal institutions (i.e. rules) that can be adjusted by the political process.
How firms can raise money without giving
suppliers of capital any real power? (A Survey of Corporate Governance)
▪ Reputation building - Managers repay investors to establish a good reputation to ensure access to the capital markets in the future.
▪ Excessive investor optimism - Investors get excited about companies, and hence finance them without thinking much about getting their money back, simply counting on short-run share appreciation. For example, Ponzi schemes like Bitconnect.
What are the reasons why the investors
invest at all? (A Survey of Corporate Governance)
–> Legal protection.
▪ External financing is a contract between the firm and the financiers that gives them certain rights to its assets. If managers violate this contract, the financiers appeal to the courts.
Countries differ by legal protection of shareholders (!). ▪ Creditors are usually better protected legally since the default is a straightforward violation of a contract.
–> Large investors
▪ 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.
▪ Similarly, In the case of firm’s default or debt covenant violation, large creditors receive substantial CF rights as well as voting rights.
Control can be also obtained in a hostile takeover.
What are the costs of large investors? (A Survey of Corporate Governance)
▪ Concentrated control diminishes agency problems, but this comes at a price.
▪ Large investors also bear larger financial consequences of their actions due to lack of diversification (remember for reading 2).
▪ Large investors might pursue their own interests and
expropriate other stakeholders (e.g. special dividends). More likely with dual- class shares structure.
▪ Large shareholders might seek the firm to pursue risky projects, as they face upward payoff, while large creditors face potential costs of failure only. Clash of interests!
▪ Large investors might be too soft due to their own agency problems (e.g. institutional investors). Ability to control does not materialize.
What is a leveraged buy out (LBOs)? (A Survey of Corporate Governance)
▪ Leveraged buy outs (LBOs): a group of new investors, highly leveraged, buy enough shares to control the firm.
▪ Large debt infusion to the company’s balance sheet disciplines managers by covenants. Managers are also given shares.
▪ A unified group of investors can now exert a concerted influence to firm’s decisions. No free-rider problem.
What is the problem with state ownership? (A Survey of Corporate Governance)
State enterprises do not appear to serve the public
interest any better. Pollution problems are in fact most severe in the post-communist countries.
▪ CG perspective: bureaucrats in control of state enterprises can be thought 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).
What are the conclusions of the reading? (A Survey of Corporate Governance)
There is no perfect corporate governance system and the paper does not seek to establish one.
▪ Successful corporate governance systems, such as those of the United States, Germany, and Japan, combine significant legal protection of at least some investors with an important role for large investors.
▪ Large investors are necessary to force managers to distribute profits. They require at least some legal rights to be able to exert pressure through votes and collateral collection.
▪ In turn, minority investors should be protected from expropriation or else very low value would be attributed to minority share blocks.
Private Benefits of Control: An
International Comparison
What are private benefits of control? What are the costs of PBOC? What are the benefits of PBOC?
▪ PBOC – benefits that are not shared among all shareholders in proportion of the shares owned, but are exclusively enjoyed by parties in control: “psychic” value, outright theft, transfer pricing, using insider info for personal gain.
▪ PBOC involves costs. Maintaining a control block means lack of diversification. Distressed companies might inflict reputational losses or even legal liabilities to the controllers.
▪ PBOC not always bad. Managers exploiting profitable investments without company’s assent might actually create value. Also, the existence of PBOC makes value-enhancing and socially beneficial takeovers possible.
Private Benefits of Control: An
International Comparison
What are the two main ways of
measuring PBOC ?
▪ Difficult to measure directly. If PBOC were easily observable and quantifiable, they would not be private and would be claimed by minority shareholders in court.
▪ Two methods of quantifying PBOC are used:
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.
▪ Both measures capture only common value component. This means that these measures do not capture everything – most likely they do not capture the psychic value as most potential buyers do not enjoy this psychic value.
Private Benefits of Control: An
International Comparison
What affects the size of PBOC premium when buying shares (theoretically)?
The authors find some evidence for higher PBOC depending only on sellers bargaining power, if the company is in distress, and whether the buyer is a foreigner. Everything else not significant.
▪ The size of block traded. You will pay more for 51% of shares than 30% because when you have 51% you are in total control. If you have only 30% your dominance might be contested. The authors find some evidence.▪ Sellers bargaining power - reflects whether seller is in a position to demand more money from the buyers.
▪ If the company is in a financial distress, a large seller is willing to sell shares for less. PBOC are then undervalued. The authors find some evidence.▪ Whether the buyer is a foreigner. Foreigners pay more (less information and connections => more bargaining power for the seller) The authors find some evidence.
Private Benefits of Control: An
International Comparison
How does high PBOC affect financial development?
Three implications apply to countries with high PBOC:
- Fewer companies are public, thus the equity markets are underdeveloped which hinders firm financing.
- Afraid of ending up in the minority position, incumbents seek to retain control after going public, thus there should be less widely held companies.
- To maximize profit, governments should sell companies privately rather than in public offerings.
Private Benefits of Control: An
International Comparison
What curbs PBOC (theoretically)? Legal vs Extra-legal institutions?
Legal institutions:
1. The legal environment. Greater ability to sue controlling shareholders and greater shareholder protection in general translate into smaller PBOC. Works
▪ Anti-director rights: the process of director appointment, length of their tenure, ability to protest decisions of the majority, etc.
2. Disclosure standards. The more extensive and accurate disclosed information is, the more it curbs appropriation by increasing the risk of legal consequences or reputational costs (SEC in the US). Works
3. Enforcement. 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). Works
Extra-Legal institutions:
1. Product market competition. Through prices, competitive markets can verify manipulated transfer prices. Competition also makes
tunneling more harmful to firm’s survival. Works
2. Public opinion pressure. Value appropriation can be limited by expected reputational. Works
3. Moral norms. Value appropriation can not be undertaken due to moral considerations. Religious traditions as a proxy? Crime rate? Do not work
4. Labor as monitor. The risk of employees quitting due to dishonest activities by majority shareholders. What if employees benefit from PBOC? Does not work
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 – better tax enforcement can reduce PBOC. Works
