Readings3 Flashcards
A Survey of Corporate Governance
What is corporate governance?
▪ Corporate governance deals with the ways in which suppliers of finance to corporations can assure themselves of getting a return on their investment. Stems from the separation of ownership.
▪ The fundamental problem of corporate governance is how to assure financiers that they get a return on their financial investment?
▪ CG mechanisms are economic and legal institutions (i.e. rules) that can be adjusted by the political process.
A Survey of Corporate Governance
What is the agency problem in the
context of CG? And what would be the ideal solution for it?
▪ 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!
A Survey of Corporate Governance
What are some of the bad things
that the management can do?
▪ 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!
A Survey of Corporate Governance
What is the possible solution for agency costs when managers are not fulfilling their fiduciary duties?
▪ 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.
A Survey of Corporate Governance
What is the evidence for agency costs?
▪ 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?
A Survey of Corporate Governance
How firms can raise money without giving
suppliers of capital any real power?
▪ 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.
A Survey of Corporate Governance
What are the reasons why the investors
invest at all?
–> 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.
A Survey of Corporate Governance
What are the costs of large investors?
▪ 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.
A Survey of Corporate Governance
Discuss: Debt vs equity
▪ 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.
A Survey of Corporate Governance
What is a leveraged buy out (LBOs)?
▪ 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.
A Survey of Corporate Governance
What is the problem with state ownership?
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).
A Survey of Corporate Governance
What are the conclusions of the reading?
There is no perfect corporate governance system and the paper does not seek to establish one.
▪ Successful corporate governance systems, such as those of the United States, Germany, and Japan, combine significant legal protection of at least some investors with an important role for large investors.
▪ Large investors are necessary to force managers to distribute profits. They require at least some legal rights to be able to exert pressure through votes and collateral collection.
▪ In turn, minority investors should be protected from expropriation or else very low value would be attributed to minority share blocks.
Private Benefits of Control: An
International Comparison
What are private benefits of control? What are the costs of PBOC? What are the benefits of PBOC?
▪ PBOC – benefits that are not shared among all shareholders in proportion of the shares owned, but are exclusively enjoyed by parties in control: “psychic” value, outright theft, transfer pricing, using insider info for personal gain.
▪ PBOC involves costs. Maintaining a control block means lack of diversification. Distressed companies might inflict reputational losses or even legal liabilities to the controllers.
▪ PBOC not always bad. Managers exploiting profitable investments without company’s assent might actually create value. Also, the existence of PBOC makes value-enhancing and socially beneficial takeovers possible.
Private Benefits of Control: An
International Comparison
What are the two main ways of
measuring PBOC ?
▪ Difficult to measure directly. If PBOC were easily observable and quantifiable, they would not be private and would be claimed by minority shareholders in court.
▪ Two methods of quantifying PBOC are used:
1. Control premium - the difference between the price per share of the control block and the market price per share. Drawbacks: Sales of control blocks are rather rare; delay in incorporating public information to the market price.
2. Price difference between shares in a dual-class system. Extra voting rights as a proxy for corporate control. Drawback: dual class shares are not allowed in every country.
▪ Both measures capture only common value component. This means that these measures do not capture everything – most likely they do not capture the psychic value as most potential buyers do not enjoy this psychic value.
Private Benefits of Control: An
International Comparison
What affects the size of PBOC premium when buying shares (theoretically)?
The authors find some evidence for higher PBOC depending only on sellers bargaining power, if the company is in distress, and whether the buyer is a foreigner. Everything else not significant.
▪ The size of block traded. You will pay more for 51% of shares than 30% because when you have 51% you are in total control. If you have only 30% your dominance might be contested. The authors find some evidence.
▪ 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
Private Benefits of Control: An
International Comparison
How does high PBOC affect financial development?
Three implications apply to countries with high PBOC:
- Fewer companies are public, thus the equity markets are underdeveloped which hinders firm financing.
- Afraid of ending up in the minority position, incumbents seek to retain control after going public, thus there should be less widely held companies.
- To maximize profit, governments should sell companies privately rather than in public offerings.
Private Benefits of Control: An
International Comparison
What curbs PBOC (theoretically)? Legal vs Extra-legal institutions?
Legal institutions:
1. The legal environment. Greater ability to sue controlling shareholders and greater shareholder protection in general translate into smaller PBOC. Works
▪ Anti-director rights: the process of director appointment, length of their tenure, ability to protest decisions of the majority, etc.
2. Disclosure standards. The more extensive and accurate disclosed information is, the more it curbs appropriation by increasing the risk of legal consequences or reputational costs (SEC in the US). Works
3. Enforcement. Quicker, smoother and more predictable enforcement, the
stronger the legal protections of shareholders (e.g. the level of corruption and bureaucracy of courts in the country). Works
Extra-Legal institutions:
1. Product market competition. Through prices, competitive markets can verify manipulated transfer prices. Competition also makes
tunneling more harmful to firm’s survival. Works
2. Public opinion pressure. Value appropriation can be limited by expected reputational. Works
3. Moral norms. Value appropriation can not be undertaken due to moral considerations. Religious traditions as a proxy? Crime rate? Do not work
4. Labor as monitor. The risk of employees quitting due to dishonest activities by majority shareholders. What if employees benefit from PBOC? Does not work
5. Government as a monitor through tax enforcement. Through taxes the state is an investor to all companies. It also has a power unavailable to regular shareholders – better tax enforcement can reduce PBOC. Works
Coase Versus The Coasians
What is Coase theorem?
▪ Coase theorem: when property rights are well defined and transaction costs are zero, market participants’ use of contracts will achieve Pareto efficient outcomes.
▪ In such an ideal world, there is no need for the government to interfere through taxes or regulations. If the assumptions are not satisfied, intervention is inevitably needed.
Coase Versus The Coasians
What is the main idea for Coasians?
▪ The Coasians have deviated from the original Coase theorem. According to them, contractors (e.g. security buyers and sellers) have a vast range of types of contracts to ensure that all possible scenarios can be dealt with by their provisions.
▪ Such contracts make most laws and regulations unnecessary. Expost judicial enforcement is enough to ensure efficient markets.
▪ The Coasian judges must be able and willing to read complicated contracts, verify that their provisions have been breached and interpret broad and ambiguous language (!).
