Guiding Seminar 4

Question 1

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

What are takeover defenses?

Answer 1

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 2

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 2

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 3

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

Compare single-class vs dual-class share companies

Answer 3

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 4

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

Why are inferior shares worth less than superior?

Answer 4

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 5

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

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

Answer 5

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 6

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 6

▪ 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 7

The bonding hypothesis of takeover
defenses: Evidence from IPO firms

What is the bonding hypothesis?

Answer 7

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 8

The bonding hypothesis of takeover
defenses: Evidence from IPO firms

Give an example of Bonding hypothesis

Answer 8

▪ 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 9

The bonding hypothesis of takeover
defenses: Evidence from IPO firms

What is an IPO puzzle? How does IPO solve it?

Answer 9

▪ Why do so many firms adopt takeover defenses when they go public?
▪ If takeover defenses lower share values as is widely presumed, it would be irrational for pre-IPO shareholders to implement them and suffer the resulting loss when shares are sold to outside investors

Answer: takeover defenses increase a firm’s value due to the bonding hypothesis (close relations of the current managers with other companies).

Question 10

The bonding hypothesis of takeover
defenses: Evidence from IPO firms

What are quasi-rents?

Answer 10

▪ 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 11

The bonding hypothesis of takeover
defenses: Evidence from IPO firms

What are the three relationships worth defending?

Answer 11

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 12

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 12

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 13

The bonding hypothesis of takeover
defenses: Evidence from IPO firms

What are the bonding effects on firm’s performance?

Answer 13

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 14

The bonding hypothesis of takeover
defenses: Evidence from IPO firms

What is meant by spillover effects in bonding hypothesis?

Answer 14

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 15

The bonding hypothesis of takeover
defenses: Evidence from IPO firms

What are the conclusions?

Answer 15

▪ 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 16

On the Foundations of
Corporate Social Responsibility

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

Answer 16

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 17

On the Foundations of
Corporate Social Responsibility

What is the legal origin?

Answer 17

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

Question 18

On the Foundations of
Corporate Social Responsibility

What are the differences in legal origins associated with CSR?

Answer 18

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 19

On the Foundations of
Corporate Social Responsibility

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

Answer 19

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

Does not impact: cultural values and religion

Question 20

On the Foundations of
Corporate Social Responsibility

What is the marginal effect theory?

Answer 20

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 21

On the Foundations of
Corporate Social Responsibility

What are the two channels of firm responsiveness?

Answer 21

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 22

On the Foundations of
Corporate Social Responsibility

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

Answer 22

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 23

On the Foundations of
Corporate Social Responsibility

What were the conclusions of the reading?

Answer 23

▪ 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 24

Active Ownership

What are ESG concerns?

Answer 24

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 25

Active Ownership

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

Answer 25

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 26

Active Ownership

What are the 4 channels of the ESG value enhancement?

Answer 26

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 27

Active Ownership

What are the two types of engagements is ESG?

Answer 27

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 28

Active Ownership

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

Answer 28

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 29

Active Ownership

What 2 factors increase the likelihood of successful engagement?

Answer 29

Likelihood of a successful engagement increases if:

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

Question 30

Active Ownership

What are the characteristics of ESG-targeted firms?

Answer 30

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 31

Active Ownership

What are the differences between ES and CG targeted firms?

Answer 31

(!) 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 32

Active Ownership

What are the market responses to ESG activism?

Answer 32

▪ 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 33

Active Ownership

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

Answer 33

▪ 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 34

Active Ownership

What are the conclusions of the reading?

Answer 34

▪ 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 35

Corporate Political Contributions and Stock Returns

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

Answer 35

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 36

Corporate Political Contributions and Stock Returns

Discuss: political contributions: Republicans vs Democrats

Answer 36

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

Question 37

Corporate Political Contributions and Stock Returns

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

Answer 37

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 38

Corporate Political Contributions and Stock Returns

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

Answer 38

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 39

Corporate Political Contributions and Stock Returns

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

Answer 39

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 40

Corporate Political Contributions and Stock Returns

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

Answer 40

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.