Week 2 Flashcards
Corporate Governance
Describe the separation between ownership and control in a company and its problem.
Shareholders provide capital but do not (usually) manage companies and managers run companies but don’t (usually) own them. Therefore, the incentives are not aligned! Shareholders want higher firm value but CEOs want higher pay with lower effort.
What is corporate governance?
The principal goal of corporate governance is to restrict expropriation of shareholders and bondholders by insiders (managers)
Why should we care about governance?
In the past, investors didn’t care much about governance. Then, in 2002, Enron defaulted. They were the 7th biggest company in the US and their CEOs and top execs were sent to prison, while the investors lost everything.
Why did Enron default?
The firm engaged in fraud, accounts manipulation, market manipulation and extreme risk-taking. Yet, no supervisory body or regulator seemed to notice for years.
Describe how the Corporate Governance failed at Enron.
The Board of Directors lacked the ability to understand the difficult financial contracts Enron was using. The auditor, Arthur Andersen, was also consultant to Enron and did not want to lose the consulting business. This auditor was also never changed. Enron created hundreds of Special Purpose Vehicles (SPVs) to hide losses, as there was no obligation to consolidate these on the balance sheets if the SPV had at least 3% independently owned capital.
The reaction to Enron’s default was the Sarbanes-Oxley Act, what does it say?
Firms must rotate auditors
A firm cannot be audited and consulted by the same company at the same time.
Firms need to consolidate the balance sheet of their SPVs.
Describe the Principal-Agent Problem.
Shareholders (principal) delegate firm management to managers (Agents). Asymmetric information means that the managers will choose a level of effort that is not observable by the shareholders. If managers choose a level of effort smaller than the optimal level, the firm value will be lower than its potential value. This difference is a cost to shareholders. Good corporate governance minimizes this cost.
What is asymmetric information?
Information is asymmetric when one party in an economic transaction has more information than the other. Consequences of asymmetric information are adverse selection and moral hazard.
What are four tools to ensure managers manage firms properly?
Board of Directors
Stock options
Market for corporate control
Activism by shareholders
What are five characteristics of the Board of Directors?
Oversee and appoint management and represent shareholders’ interests.
Evaluates management and design compensation contracts.
Approves strategic direction, business plans and budgets.
Elected by the shareholders.
A certain fraction of board members need to be independent for the company to be listed.
Companies hold a shareholder meeting annually and in this meeting, shareholders are asked to vote on key matters (Proxy Voting) and to select the Board Members. Managers can/must ask shareholders to vote on key issues.
Describe the OpenAI conflict between CEO and Board.
Board fires CEO Sam Altman over a disagreement on business strategy.
Microsoft (main shareholder) replaces board members and reinstate Sam Altman as CEO less than a week later.
–> Board needs to represent the shareholders.
How can we incentivize managers to optimal effort with stock options?
Company can give long call options where the manager can buy the shares at the exercise price. Therefore, the option will be ‘out of money’ if the stock price is below the exercise price but when the stock price rises above the manager is ‘in the money’ and earns extra money. However, a company can also decide to punish a manager when the stock price falls through forcing the manager to short a put option on which the company is long. Therefore, the manager has the obligation to buy the stock if the company exercises its option and when the stock price is below the exercise price, the manager loses money.
What are drawbacks of using stock options to incentivize?
CEOs have a tendency to pick high-risk business strategies to boost stock prices.
Stock options may be too far underwater to motivate the manager effectively.
Skip costly costly research and development that might be beneficial for the firm because it gives no direct benefits to stock price.
Hence, stock options could promote short term behavior instead of healthy, long-term.
Accounting profits may be manipulated.
If the executive exercises the option and sells the stock, incentives are not aligned anymore –> therefore, vesting period is used (no allowed to sell)
Stock prices are affected by company performance but also by many other factors.
How are managers incentivized through the market of corporate control?
These market forces incentivize managers to work hard. If managers do not maximize firm value, the firm will trade at a discount with respect to its potential value. This means that somebody could make a profit by buying the firm at the discounted price, change the management, and selling it at the higher price, thereby making a profit equal to the difference.
