Guiding seminar 4 (2020)

Question 1

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 1

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 2

The Agency Problems of Institutional Investors

What are stewardship activities?

Answer 2

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 3

The Agency Problems of Institutional Investors

What are the types of institutional investors?

Answer 3

▪ 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 4

The Agency Problems of Institutional Investors

Why has the popularity of index funds grown?

Answer 4

Growing popularity of index funds is mainly driven by the recognition of their low costs, tax advantages and the evidence that they actually outperform actively managed funds (!).

Question 5

The Agency Problems of Institutional Investors

How do active funds solve the agency problem of increasing relative performance?

Answer 5

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 6

The Agency Problems of Institutional Investors

What is the one main agency problem here?

Answer 6

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 7

The Agency Problems of Institutional Investors

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

Answer 7

▪ 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 8

The Agency Problems of Institutional Investors

What are the limits of hedge funds?

Answer 8

▪ 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 9

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 9

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 10

The Agency Problems of Institutional Investors

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

Answer 10

▪ 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 11

Corporate Political Contributions and Stock Returns

What does previous research say on the relationship between business and politics?

Answer 11

Previous research documents that more contributions from special interest groups increases the chances of a legislator being elected. Moreover, influential legislators raise substantially more funds than less their less prominent peers

▪ Previous research suggests that connectedness with politics appears to be important for company’s value.
▪ Companies experience positive value changes following the news that their shareholders are elected to prominent government positions.
▪ Having an insider in the important governmental position, increases the likelihood of such companies being bailed out in the case of financial distress.
▪ Similarly, the death or resignation declared by contributions’ addressee in the office entails a detrimental effect to company’s value.
▪ In general, stock price responses of connected firms to different political news are greater in more corrupt countries.

Question 12

Corporate Political Contributions and Stock Returns

Discuss: political contributions: Republicans vs Democrats

Answer 12

On average, Republican candidates get more corporate contributions than Democrat candidates.

Question 13

Corporate Political Contributions and Stock Returns

What does ad what does not show the real engagement in politics for a firm?

Answer 13

Monet per candidate is not a good measure due to “soft money”, so rather measure the number of candidates supported.

Despite lower amounts in total, corporations are making relatively larger contributions. Thus, they are also more likely to be noticed and distinguished by the receiving candidates.
▪ Corporate contributions constitute a small part (about 10%) of candidates’ financing, the major part coming from individuals.
▪ Contributions to candidates fluctuate around $2k per candidate. Irrespective to the number of candidates supported. This number is well below the upper limit of $10k.
▪ “soft money” (e.g. non-monetary contributions, favors and off-thebooks benefits) may have a significant role in establishing a link with a candidate.
▪ Thus, the number of candidates supported rather than disclosed financial contributions shows the real engagement in politics.
▪ On average, a contributing company supports 72.5 candidates over the 5 year period and 53.2 of them win the race.

Question 14

Corporate Political Contributions and Stock Returns

What are the three factors that determine whether to support the candidate?

Answer 14

1. Ability to help. Officers that hold office in the same state that contributing company resides also have a greater influence on favorable policies.
2. Strength of the relationship. Longer uninterrupted relations with politicians make them more trustworthy. The relationship also grows stronger for candidates belonging to the party in control.
3. Power of the candidate. Due to their greater ability to influence policies, important committee members or chairmen raise substantially more money.

Question 15

Corporate Political Contributions and Stock Returns

What are the characteristics for a firm, which is likely to engage in politics?

Answer 15

1. Large companies with more sales and more employees
2. Lower returns in the previous 36 months, higher B/M and higher leverage
3. Companies in regulated industries and industries involving government purchases

Question 16

Corporate Political Contributions and Stock Returns

What is the relationship between a firm and its corporate political contributions?

Answer 16

There is a strong and robust positive correlation between corporate political contributions and firm’s abnormal future returns. Real performance, measured by ROE, is also enlarged.
More political contributions–> higher abnormal future returns.

▪ The effect is stronger for firms that support higher number of candidates holding office in the same state the firm is based in.
▪ Political contributions can be seen as strongly positive NPV investments. However, ambiguity surrounding the actual value of “soft money” as contributions might conceal true costs of
companies engaging in politics.
▪ An alternative explanation these abnormal returns could be that politicians might find it most beneficial to grant favors for large companies as they are the largest tax payers and employers.

Question 17

Active Ownership

What are ESG concerns?

Answer 17

Environmental, social and governance (ESG) concerns :
▪ Environmental engagements typically concern climate change, water issues.
▪ Social concerns - human rights, public health and labor standards.
▪ Governance - audit and control, executive compensation.
ESG activism in a firm advocates for the interest of a
broader range of stakeholders, not just shareholders.

Question 18

Active Ownership

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

Answer 18

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 19

Active Ownership

What are the 4 channels of the ESG value enhancement?

Answer 19

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 20

Active Ownership

What are the two types of engagements is ESG?

Answer 20

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%).

Question 21

Active Ownership

ESG success rate still lags far behind
hedge funds’ track record. What are the two reasons why?

Answer 21

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.

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 22

Active Ownership

What 2 factors increase the likelihood of successful engagement?

Answer 22

Likelihood of a successful engagement increases if:

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

Question 23

Active Ownership

What are the characteristics of ESG-targeted firms?

Answer 23

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).

Question 24

Active Ownership

What are the differences between ES and CG targeted firms?

Answer 24

(!) 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 25

Active Ownership

What are the market responses to ESG activism?

Answer 25

▪ 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.
▪ 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.
▪ 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 26

Active Ownership

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

Answer 26

▪ 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.

Question 27

Active Ownership

What are the conclusions of the reading?

Answer 27

▪ 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.

Question 28

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 28

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 29

Private Benefits of Control: An
International Comparison

What are the two main ways of
measuring PBOC ?

Answer 29

▪ 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 30

Private Benefits of Control: An
International Comparison

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

Answer 30

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 31

Private Benefits of Control: An
International Comparison

How does high PBOC affect financial development?

Answer 31

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 32

Private Benefits of Control: An
International Comparison

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

Answer 32

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 33

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

What are takeover defenses?

Answer 33

In simple terms, these are things that make takeovers very difficult and expensive.
For example,
1. Charter amendments (imposing conditions on control transfer- require over 2/3 of votes to approve merger),
2. Golden parachute (lucrative severance package guaranteed to the management if the firm is taken over and the managers are let go).
3. Poison pills- securities with embedded rights to buy shares at a deeply discounted price in either the target or an acquirer–> acquisition prohibitively expensive
4. Pac man defense- target firm counteroffers for bidder firm.

Question 34

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

What 2 types of shares a typical dual-class company has? What are the differences between them?

Answer 34

A typical dual-class company has two types of shares:

1. Superior shares with ten votes per share, not publicly traded.
2. Inferior class, with one vote per share, publicly traded.

▪ Superior class of shares is usually owned by company insiders (e.g. managers). It provides insiders with a majority of votes despite much lower cash flow rights in their possession. 
▪ Thus, the insiders of dual-class firms have effective control over all corporate decisions. It makes them virtually immune to hostile takeovers.

Question 35

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

Compare single-class vs dual-class share companies

Answer 35

Compared to single-class firms, dual-class firms are:
▪ Bigger on median terms ($295m versus $100m).
▪ More levered, possible due to their reluctance to engage in equity offerings not to lose ownership or it is possible that debt is used as an alternative control mechanism (18% versus 6% debt-to-assets ratio).
▪ Older, possibly due to less possibility of being acquired (12.9 years versus 9.6).

Question 36

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

Why are inferior shares worth less than superior?

Answer 36

One-vote shares are worth less under the dual-class structure. This is because inferior shareholders have less control and thus can be more easily expropriated leading to a worse performance of the firm. Superior shareholders, on the other hand, enjoy PBOC.

Question 37

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

What predicts larger size of PBOC and thus dual-class status?

Answer 37

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. Firms in the area & Sales of the area.
   • The fewer firms there are in the 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.
   • 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.

Question 38

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

What are the paper’s findings of relations with the firm’s value?

Answer 38

▪ Firm value is positively associated with insiders’ cash-flow rights.
▪ Firm value is negatively associated with insiders voting rights.
▪ Firm value is negatively associated with the wedge between the two (insider voting rights – insider cash flow rights).

Question 39

The bonding hypothesis of takeover
defenses: Evidence from IPO firms

What is the bonding hypothesis?

Answer 39

The “bonding hypothesis” examines another path of how takeover defenses create value:
▪ (!) Defenses commit firm to a prearranged business strategy whose reversal is complicated and costly. This ensures the company’s business partners that the company will not act opportunistically and appropriate them, encouraging partners to make relation-specific
investments. This allows the company to gain favorable contract terms with its partners, which increases firm value.

Question 40

The bonding hypothesis of takeover
defenses: Evidence from IPO firms

Give an example of Bonding hypothesis

Answer 40

▪ The largest customer of Pemstar Inc., engineering services provider, was IBM (accounting for 37% of its sales in 2000).
▪ IBM invested heavily to the relationship with Pemstar, engaging in joint ventures and sharing knowledge of its production.
▪ This created a “hold-up problem”: Pemstar could have exploited IBM’s reliance and demanded higher payments, payable by IBM in the short term, but hindering the relationship in the long run.
▪ What kept Pemstar from acting opportunistically was that Pemstar’s managers had personal connections and reputations that would be hurt if they “betrayed” IBM for a short term gain.
▪ This would be of no value if Pemstar’s incumbents were replaced by new managers lacking such connections.
▪ Pemstar defended from 5 takeover attempts after its IPO to ensure the mutually beneficial relationship with IBM. In turn, this motivated IBM to invest in the relationship further.
▪ This is how takeover relationships can be valuable – they can be used to defend a mutually beneficial relationship.

Question 41

The bonding hypothesis of takeover
defenses: Evidence from IPO firms

What are quasi-rents?

Answer 41

▪ The main idea of the bonding hypothesis is that takeover defenses support a firm’s commitment not to act opportunistically to appropriate(take) its counterparties’ quasi-rents.
▪ Quasi-rents arise when a counterparty makes a relationship-specific investment that would lose value if the firm changes its operating strategy.

Question 42

The bonding hypothesis of takeover
defenses: Evidence from IPO firms

What are the three relationships worth defending?

Answer 42

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 (e.g. RenaultNissan Alliance).

Question 43

The bonding hypothesis of takeover
defenses: Evidence from IPO firms

To what 4 measures of the business relationship’s value are the number of takeover defenses positively related to?

Answer 43

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 44

The bonding hypothesis of takeover
defenses: Evidence from IPO firms

What are the bonding effects on firm’s performance?

Answer 44

If the business ties are present, then:

1. More takeover defenses–> higher ROA and higher valuation of the IPO firm
2. IPO is good news to a firm’s large customers–>IPO can reduce firm’s financial constraints and enable larger investments to the relationship
3. At the same time, IPO bad news for the trading partners (puts business relationship at risk). Higher potential payoff associated with higher risk that the relationship could be damanged.
4. Spillover effects- more defenses associated with larger positive returns of the firm’s large customers. (and negative returns for partners when the IPO firm is acquired). The customers depend on the firm and the long-lasting relationship.

Question 45

The bonding hypothesis of takeover
defenses: Evidence from IPO firms

What is meant by spillover effects in bonding hypothesis?

Answer 45

Spillover effects- more defenses associated with larger positive returns of the firm’s large customers. (and negative returns for partners when the IPO firm is acquired). The customers depend on the firm and the long-lasting relationship.

Question 46

The bonding hypothesis of takeover
defenses: Evidence from IPO firms

What are the conclusions?

Answer 46

▪ Takeover defenses protect managers from being replaced who then maintain their promised commitments in business relations with large customers, suppliers or partners in alliance.
▪ Firm’s business partners are then encouraged to make further relation-specific investments that are mutually beneficial.
▪ The closer the business relationship, the more takeover defenses are employed for its protection.
▪ More philosophical standpoint: contracts arise when the costs of executing them are less than the gains from trade (Coase theorem).
Antitakeover defenses economize on having to build new contracts of business relationships from scratch, increasing net gains from trade.
▪ Only young IPO firms are under the scope of the paper. What if with age, relationships are no longer worth defending?

Question 47

On the Foundations of
Corporate Social Responsibility

What is CSR? And why do firms engage in CSR?

Answer 47

Investing in environmental-friendly production, organizing projects to help the poor and other similar stakeholder- orientated activities, described by a term corporate social responsibility (CSR), has become a mainstream business activity. Why bother doing good
for the society?
▪ The common explanation for why companies invest in CSR is that doing so enhances profitability and firm value, a relationship often referred as to “doing well by doing good”.
▪ These arguments leave the bigger picture puzzles hardly touched upon. Why do firms in some countries systematically invest more in CSR than firms in other countries?

Question 48

On the Foundations of
Corporate Social Responsibility

What is the legal origin?

Answer 48

Legal origin: a system of social control of economic life (!).

Question 49

On the Foundations of
Corporate Social Responsibility

What are the differences in legal origins associated with CSR?

Answer 49

On average firms under a civil law system have a higher CSR score than those under the common law.

▪ Common law countries uphold private market outcomes as well profit maximization as factors leading to the action in the best interests of all stakeholders.
▪ Less regulation, more freedom for firm discretion. Contract enforcement based on ex-post judicial mechanisms (after the problem occurs, only then solve it).

▪ Contrarily, civil law countries acknowledge private market failures leading to inefficiencies. The state plays a crucial role in coordinating private markets by stricter stakeholder protection laws.
▪ From this, regulations are born. Firms have their freedom, but limited by ex-ante restrictions on certain behavior (try to solve the problem (with regulations) before the problem occurs).

▪ CSR adoption in common law countries is typically a voluntary decision, while CSR adoption in civil law countries is determined by rules.
▪ In the civil law countries, firms investing to CSR as mandated by law: no risk of potential litigations from stakeholders.
▪ 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.
▪ In general, CSR level in a country is thus a result of the tradeoff concerning the rights and preferences of shareholders and other stakeholders.

Question 50

On the Foundations of
Corporate Social Responsibility

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

Answer 50

Does impact: legal origins (higher CSR scores in civil law countries)

Does not impact: cultural values and religion

Question 51

On the Foundations of
Corporate Social Responsibility

What is the marginal effect theory?

Answer 51

The “marginal” effect theory: civil law firms outperform because they are more responsive to the shocks changing the demand for CSR actions.
Two channels of firm responsiveness:
▪ Consumer channel – shocks trigger changes in consumer demand affecting the market value which forces firms to adjust their CSR.
▪ Legal channel – firms in more stakeholder-orientated legal environments tend to be more responsive to shocks.
▪ Consumer channel does not differ between firms in civil and common law countries, which leaves the legal channel accountable for differences in responsiveness across legal regimes.

Question 52

On the Foundations of
Corporate Social Responsibility

What are the two channels of firm responsiveness?

Answer 52

Two channels of firm responsiveness:
▪ Consumer channel – shocks trigger changes in consumer demand affecting the market value which forces firms to adjust their CSR.
▪ Legal channel – firms in more stakeholder-orientated legal environments tend to be more responsive to shocks.
▪ Consumer channel does not differ between firms in civil and common law countries, which leaves the legal channel accountable for differences in responsiveness across legal regimes.

Question 53

On the Foundations of
Corporate Social Responsibility

Compare with examples the actions of civil and common law countries when CSR problems arise?

Answer 53

Firms in the civil law countries compared to those in the common law countries:
▪ Improved their food safety checks more relatively more in response to the 2008 Chinese milk scandal.
▪ Donated on average more money (relative to cash holdings) in response to the 2004 Indian Ocean earthquake.
▪ Strengthened pollution controls, invested more in green R&D in response to the Deepwater Horizon oil spill of 2010.

Question 54

On the Foundations of
Corporate Social Responsibility

What were the conclusions of the reading?

Answer 54

▪ Law and finance literature, focused mostly on how legal rules affect investor rights as well as economic outcomes, has virtually ignored their effects on the welfare of other stakeholder (a firm should care about all stakeholders, not just shareholders).
▪ Due to their stakeholder-orientated perspective, civil law systems support CSR to a larger extent than common law regimes.
▪ So, why do companies bother doing good for the society? If you find yourself in the civil law system, you do not have a choice.

Question 55

A Survey of Corporate Governance

What is corporate governance?

Answer 55

▪ 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 56

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 56

▪ 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 57

A Survey of Corporate Governance

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

Answer 57

▪ 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 58

A Survey of Corporate Governance

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

Answer 58

▪ 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 59

A Survey of Corporate Governance

What is the evidence for agency costs?

Answer 59

▪ 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 60

A Survey of Corporate Governance

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

Answer 60

▪ 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 61

A Survey of Corporate Governance

What are the reasons why the investors
invest at all?

Answer 61

–> 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 62

A Survey of Corporate Governance

What are the costs of large investors?

Answer 62

▪ 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 63

A Survey of Corporate Governance

Discuss: Debt vs equity

Answer 63

▪ 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 64

A Survey of Corporate Governance

What is a leveraged buy out (LBOs)?

Answer 64

▪ 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 65

A Survey of Corporate Governance

What is the problem with state ownership?

Answer 65

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 66

A Survey of Corporate Governance

What are the conclusions of the reading?

Answer 66

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 67

Behind the Scenes: The Corporate
Governance Preferences of
Institutional Investors

What are institutional investors?

Answer 67

▪ 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 68

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 68

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 69

Behind the Scenes: The Corporate
Governance Preferences of
Institutional Investors

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

Answer 69

▪ 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 70

Behind the Scenes: The Corporate
Governance Preferences of
Institutional Investors

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

Answer 70

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 71

Behind the Scenes: The Corporate
Governance Preferences of
Institutional Investors

Discuss: Voice and Exit: substitutes or complements.

Answer 71

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 72

Behind the Scenes: The Corporate
Governance Preferences of
Institutional Investors

What determines the effectiveness of the threat of exit?

Answer 72

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 73

Behind the Scenes: The Corporate
Governance Preferences of
Institutional Investors

What discourages shareholder activism?

Answer 73

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 74

Behind the Scenes: The Corporate
Governance Preferences of
Institutional Investors

What encourages shareholder
activism?

Answer 74

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 75

Behind the Scenes: The Corporate
Governance Preferences of
Institutional Investors

What are proxy advisors? Discuss costs and benefits of them

Answer 75

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.