Guiding Seminar 3 - Corporate Governance

Question 1

A Survey of Corporate Governance

What is corporate governance?

Answer 1

▪ 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.

Question 2

A Survey of Corporate Governance

What is the agency problem in the
context of CG? And what would be the ideal solution for it?

Answer 2

▪ A conflict, known as an “agency problem,
“ arises when there is a conflict
of interest between the needs of the principal and the needs of the agent. The manager should fulfill his fiduciary duty towards the shareholder, but in reality, the manager might take actions that benefit only him.
▪ Ideally, a financier would sign a contract with a manager that specifies a division of profits and the manager’s actions in all states of the world. But
such contracts are infeasible!
▪ Instead, contracts should specify who has residual control rights – i.e. who makes decisions in unforeseen circumstances.
▪ Managers are more skilled. As a consequence,
managers have most of the residual control rights.

In practice, problems arise:
▪ Corporate contracts cannot require too much interpretation (i.e. cannot be very complicated) – otherwise, courts might not help.
▪ Also, the free-rider problem of shareholders. Even more control for managers!

Question 3

A Survey of Corporate Governance

What are some of the bad things
that the management can do?

Answer 3

▪ Expropriation can happen via direct absconsion with the money as well as more subtle ways - transfer pricing, empire building, pursuing pet projects or entrenching in the position.
▪ Knowing this, investors are willing to provide less funds for the firm. Lack of external financing!

Question 4

A Survey of Corporate Governance

What is the possible solution for agency costs when managers are not fulfilling their fiduciary duties?

Answer 4

▪ Possible solution - Incentive contracts: making managers interested in increasing shareholder value (e.g. by share ownership, stock options).
▪ However, with more information, they might know when earnings are going to rise, or manipulate accounting data.
▪ Thus, incentive contracts can be turned into a mechanism of selfdealing and is not a panacea to the agency problem.

Question 5

A Survey of Corporate Governance

What is the evidence for agency costs?

Answer 5

▪ 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!
▪ Manager’s resistance to the value-enhancing takeover signals the existence of PBOC and thus agency problems.
▪ Sudden deaths of executives sometimes increase the share price.
▪ Large blocks of shares carry more control and thus trade at a large premium. Large blockholders receiving special benefits?

Question 6

A Survey of Corporate Governance

How firms can raise money without giving
suppliers of capital any real power?

Answer 6

▪ 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.

Question 7

A Survey of Corporate Governance

What are the reasons why the investors
invest at all?

Answer 7

–> 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.

Question 8

A Survey of Corporate Governance

What are the costs of large investors?

Answer 8

▪ 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.

Question 9

A Survey of Corporate Governance

Discuss: Debt vs equity

Answer 9

▪ Due to information asymmetry, raising equity finance can be costly. Without much information, equity investors face more risk and attribute low value to firm’s shares.
▪ On the other hand, lenders mainly care about the value of collateral, thus firms frequently issue debt before equity. Debt covenants also pressure the managers.
▪ Due to lenders (banks, especially) having almost monopoly control of the firm in the case of default, concerted action by multiple creditors is not required (!).
▪ Still, large shareholders or takeovers can make virtually all corporate decisions in non-default times.

Question 10

A Survey of Corporate Governance

What is a leveraged buy out (LBOs)?

Answer 10

▪ 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.

Question 11

A Survey of Corporate Governance

What is the problem with state ownership?

Answer 11

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).

Question 12

A Survey of Corporate Governance

What are the conclusions of the reading?

Answer 12

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.

Question 13

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?

Answer 13

▪ 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.

Question 14

Private Benefits of Control: An
International Comparison

What are the two main ways of
measuring PBOC ?

Answer 14

▪ 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.

Question 15

Private Benefits of Control: An
International Comparison

What affects the size of PBOC premium when buying shares (theoretically)?

Answer 15

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.
▪ Presence of another large shareholder. If there is another large shareholder - you have to share your PBOC – you are not happy - you pay less. Not significant
▪ 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.
▪ Industry. PBOC also differ across industries. Controlling a media company gives you enormous power of manipulating public opinion in personally beneficial ways. Not significant
▪ The tangibility of assets. If a company’s assets are mostly tangible, they are harder to expropriate due to their visibility, thus lowering PBOC. Finance industry as a contrast. Not significant

Question 16

Private Benefits of Control: An
International Comparison

How does high PBOC affect financial development?

Answer 16

Three implications apply to countries with high PBOC:

1. Fewer companies are public, thus the equity markets are underdeveloped which hinders firm financing.
2. Afraid of ending up in the minority position, incumbents seek to retain control after going public, thus there should be less widely held companies.
3. To maximize profit, governments should sell companies privately rather than in public offerings.

Question 17

Private Benefits of Control: An
International Comparison

What curbs PBOC (theoretically)? Legal vs Extra-legal institutions?

Answer 17

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

Question 18

Behind the Scenes: The Corporate
Governance Preferences of
Institutional Investors

What are institutional investors?

Answer 18

▪ An institutional investor is an entity which pools money to purchase securities, real property, and other investment assets or originate loans. Institutional investors include banks, insurance companies,
hedge funds, investment advisors, endowments, and mutual funds.

Question 19

Behind the Scenes: The Corporate
Governance Preferences of
Institutional Investors

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

Answer 19

1. Voice – engaging with management to try to initiate changes.
2. Exit – leave the firm by selling shares.
   ▪ Threat of exit can also serve as a disciplinary action.

Question 20

Behind the Scenes: The Corporate
Governance Preferences of
Institutional Investors

What were the findings of authors? What action had the shareholders undertaken?

Answer 20

▪ Institutional investors are active overall: only 19% of the surveyed have not taken any corrective actions in the past 5 years.
▪ >50% have used discussions with management and voting against management as corporate governance channel.
▪ 39% have sold shares due to dissatisfaction with corporate governance.
▪ Only when private discussions and negotiations fail to achieve the goal, investors tend to take public measures.
▪ Aggressive public measures are also extensively used:
▪ 15% have used legal actions (!).
▪ 13% have used public criticism.

Question 21

Behind the Scenes: The Corporate
Governance Preferences of
Institutional Investors

What are the determinants of voice intensity? Is the relationship positive or negative?

Answer 21

1. Stock liquidity- authors find negative relationship- more liquid shares (easier to sell), less they intervene –> why bother if the shares are easy to sell?
   Opposing view- higher liquidity should make it easier to sell at a higher price–> should engage today and sell tomorrow.
2. Investment horizon- positive relationship- long term orientation provides more incentives to monitor and intervene since they capture the long-term benefits and had more time to gather information.
   Opposing view: hedge funds intervene more to get higher returns in the short run on expense of future returns.
3. The size of stake- no significant findings.
   – Maybe more shares mean more absolute payoff and should encorouge activism
   –Or maybe larger funds have also more resources to engage

Question 22

Behind the Scenes: The Corporate
Governance Preferences of
Institutional Investors

Discuss: Voice and Exit: substitutes or complements.

Answer 22

The paper finds robust positive correlation between the two variables, suggesting that they are complements.

Voice and (threat of) exit are complements (i.e. used simultaneously or one after the other) due to the following reasons:
▪ “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.

They might be substitutes (used separately, one or the other) as well:
▪ Some investors might lack the expertise of intervention and thus rely solely on the exit strategy.
▪ Investors might face capital gains costs when exiting, which makes the option of voice more attractive.

Question 23

Behind the Scenes: The Corporate
Governance Preferences of
Institutional Investors

What determines the effectiveness of the threat of exit?

Answer 23

1. Well informed investors collect private information on the fundamental firm value and incorporate it in the price they offer in the case of exit
2. If other investors threaten to exit for the same reasons
3. If the managers own equity themselves
4. If the size of the equity stake is significant
5. If multiple informed shareholders, then they pose more threat to firm’s value in case of exit.

Question 24

Behind the Scenes: The Corporate
Governance Preferences of
Institutional Investors

What discourages shareholder activism?

Answer 24

1. Free-rider problem (they personally incur costs of activism while the benefits are shared among others)
2. Inadequate legal rules affect activism (e.g. weak disclosure requirements or diversification requirements for mutual funds)
3. Aggressive engagement might affect their future relations with the firm
4. If they are not sufficiently rewarded, then will not engage (compensation problem).

Question 25

Behind the Scenes: The Corporate
Governance Preferences of
Institutional Investors

What encourages shareholder
activism?

Answer 25

1. If long-run strategic issues
2. If fraud
3. If inadequate corporate governance and excessive compensation
4. If disagreement with firm’s strategy (large mergers and acquisitions)
5. Contributions to politicians

Question 26

Behind the Scenes: The Corporate
Governance Preferences of
Institutional Investors

What are proxy advisors? Discuss costs and benefits of them

Answer 26

If shareholders cannot monitor the firm themselves, they will hire a proxy advisor to help them.
▪ 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.
▪ As much as 60% of respondents use at least one proxy.
▪ However, recommendations of proxy advisers can be too standardized and ignoring firm-specific cases.
▪ Recommendations are also hard to evaluate due to lack of transparency in their criteria.
▪ Proxy advisors, as profit-seeking organizations, are incentivized to conduct low-cost analyses only.
▪ Some proxy advisors serve as corporate governance advisory firms and make recommendations on voting at the same time. Conflict of interest might arise.

Question 27

The Agency Problems of Institutional Investors

What are the three problems for investment managers of index funds, which explain why they do not want to engage in stewardship activities?

Answer 27

1. Difficult to increase the relative performance through stewardship activities - free-rider problem. Even if they increase their assets under management- relative to the index and relative to the rivals the fund is unchanged (since if the index fund increases a firm’s value–> the value of the tracked index increase as well–> which increases also the rivals’ value).
2. They bear full costs of stewardship, but capture only a fraction of benefits created. (for the investment manager payoff of engagement is very small–> no incentive to engage). –> some clients are incentivized to switch to the competitors (since lower fees for stewardship)
3. They suffer from private costs (e.g. worse relations by taking positions that corporatre mangers disfavor). Only willing to do so if the fraction-based payoff is larger than stewardship costs plus private costs.

Question 28

The Agency Problems of Institutional Investors

What are stewardship activities?

Answer 28

Stewardship activities are engagement with public companies to promote corporate governance practices that are consistent with encouraging longterm value creation for shareholders in the company.
▪ Voting in shareholder meetings (and being informed when voting)
▪ Monitoring corporate managers
▪ 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?

Question 29

The Agency Problems of Institutional Investors

What are the types of institutional investors?

Answer 29

▪ Investment funds pool together the assets of many individuals and invest them in a diversified portfolio of securities (actively or passively).
▪ In this reading we look at 3 types of institutional investors:
▪ Index funds (Passive)
▪ Active funds (most of them are “closet indexers”)
▪ Hedge funds (very active)
▪ Index fund market is dominated by the “Big Three” that collectively have more than $7.5 trillion assets under management.

Question 30

The Agency Problems of Institutional Investors

Why has the popularity of index funds grown?

Answer 30

Active funds are closet indexers- they follow the same index, but they under or overweight some stocks.
Thus, if they increase the performance of a firm, which weights more heavily in their portfolio than in index’s, they improve their relative performance.
However, if the other rivals also have that stock overweighted, then the relative return will still be smaller due to stewardship costs.

Question 31

The Agency Problems of Institutional Investors

What is the one main agency problem here?

Answer 31

Intitutional 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.

Question 32

The Agency Problems of Institutional Investors

Why are hedge funds superior to mutual funds in solving the agency problem?

Answer 32

▪ Hedge funds (very active) offer services to sophisticated investors, thus their regulations are more lenient. 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.
▪ Hedge funds hold significant (10%+) stakes in a few companies, capturing much more value from stewardship activities relative to mutual funds or the index.
▪ The returns of activist hedge funds are weakly correlated with each other. Every slight performance difference signals fund superiority.

Question 33

The Agency Problems of Institutional Investors

What are the limits of hedge funds?

Answer 33

▪ Hedge fund 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.
▪ 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. A mismatch of interests?
▪ Without mutual fund support, hedge funds are hardly a threat to the corporate management.

Question 34

The Agency Problems of Institutional Investors

What are the possible systematic improvements to increase the stewardship activities of mutual funds & decreasing the agency costs?

Answer 34

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 35

The Agency Problems of Institutional Investors

What are the implications caused by agency problems of institutional investors?

Answer 35

▪ Agency problems of institutional investors prevent the full realization of the potential benefits of the increased concentration of shareholders.
▪ 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 been 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.

Question 36

Active Ownership

What is socially responsible investing?

Answer 36

▪ 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.
▪ Environmental engagements typically concern climate change, water issues.
▪ Social concerns - human rights, public health and labor standards.
▪ Governance - audit and control, executive compensation.
▪ 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…

Question 37

Active Ownership

What are the 3 different predictions on how CSR practices affect firm value according to theoretical literature?

Answer 37

▪ Theoretical literature offers 3 different predictions of how CSR practices affect firm value:

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 38

Active Ownership

What are the 4 channels through which ESG activities can increase firm value?

Answer 38

▪ Literature distinguishes 4 channels through which ESG activities can
Increase firm value:
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 (SRI 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 39

Active Ownership

What are the types of engagement? Why CG success rate still lags far behind hedge fund’s track record? When likelihood of successful engagement increases?

Answer 39

▪ Two types of engagements:
1. Raising Awareness – warning companies about certain ESG issues.
2. Request for Change – specific changes are asked (more strict step).
▪ Engagements on environmental and social issues have considerably lower success rate (13.1%) than on corporate governance (24.2%). Moreover, CG success rate still lags far behind hedge funds’ track record. Two reasons why:
1. Managers doubt the value of engaging in costly projects to potentially benefit non-shareholders.
2. ESG engagement is less aggressive compared to hedge funds’ activism.
▪ Likelihood of the successful engagement increases if:
1. There is successful prior engagement with the same firm.
2. Other shareholders collaborate.

Question 40

Active Ownership

Name the determinants of successful ESG enagement

Answer 40

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 succumb to reputational concerns (e.g. Nike).
   ▪ The stronger these factors, the higher likelihood of engagement success.
   ▪ (!) 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.

Question 41

Active Ownership

Discuss market responses to ESG activism

Answer 41

▪ 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. Abnormal returns are highest on corporate governance (8.6%) and climate change issue (10.3%) engagements. Successful ESG activism also decreases stock volatility (the firm becomes less risky).
▪ 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.
▪ There is no market reaction after Unsuccessful engagement (!).
▪ 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).
▪ ESG improvements in the target firms are not a result of superior future performance (as argued before)

Question 42

Active Ownership

What do authors conclude?If ESG policies are so beneficial, why firms might not voluntarily pursue these strategies

Answer 42

▪ Targeted firms have poorer corporate governance hindering the initiation of ESG policies.
▪ In the absence of active owners, companies might fail to identify ESG opportunities.
▪ ESG activism increases stakeholder value when engagements are successful and does not destroy value even when activism fails. It’s a win-win lottery.
▪ Responsible investment initiatives are less confrontational, more collaborative and benefits society at large.