Corporate Governance Flashcards

Corporate Governance

1
Q

Describe the separation between ownership and control in a company and its problem.

A

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.

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2
Q

What is corporate governance?

A

The principal goal of corporate governance is to restrict expropriation of shareholders and bondholders by insiders (managers)

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3
Q

Why should we care about governance?

A

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.

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4
Q

Why did Enron default?

A

The firm engaged in fraud, accounts manipulation, market manipulation and extreme risk-taking. Yet, no supervisory body or regulator seemed to notice for years.

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5
Q

Describe how the Corporate Governance failed at Enron.

A

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.

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6
Q

The reaction to Enron’s default was the Sarbanes-Oxley Act, what does it say?

A

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.

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7
Q

Describe the Principal-Agent Problem.

A

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.

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8
Q

What is asymmetric information?

A

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.

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9
Q

What are four tools to ensure managers manage firms properly?

A

Board of Directors
Stock options
Market for corporate control
Activism by shareholders

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10
Q

What are five characteristics of the Board of Directors?

A

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.

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11
Q

What is done in an annual shareholder meeting?

A

Shareholders vote on key firm matters (proxy voting)
Shareholders vote on board members
Shareholders can propose new policies
Managers can ask shareholders to vote on certain matters

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12
Q

Describe the OpenAI conflict between CEO and Board.

A

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.

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13
Q

How can we incentivize managers to optimal effort with stock options?

A

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.

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14
Q

What are drawbacks of using stock options to incentivize?

A

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.

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15
Q

How are managers incentivized through the market of corporate control?

A

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.

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16
Q

What are antitakeover protections?

A

Bad/lazy managers have an incentive to insulate themselves from the risk of being acquired (and fired afterwards). They can do that by adopting antitakeover protections that make an acquisition more expensive/more difficult for the buyer.

17
Q

What are examples of antitakeover protections?

A

Poison pill
Staggered board
White knight
Golden parachute
Dual-class shares

18
Q

What is a poison pill?

A

A poison pill is designed to discourage a major acquisition of shares and a company’s hostile takeover by an individual or entity. Once activated, the strategy allows shareholders, with the exception of the acquiring party, to buy additional shares of company stock at a highly discounted price.

19
Q

What is a staggered board?

A

A board of directors whose three-year terms are staggered so that only one-third of the directors are up for election each year. A bidder’s candidate would have to win a proxy fight two years in a row before the bidder had a majority presence on the target board.

20
Q

What is a white knight?

A

A target’s company defense against a hostile takeover attempt in which it looks for another, friendlier company to acquire it.

21
Q

What is a golden parachute?

A

An extremely lucrative severance package that is guaranteed to a firm’s senior management in the event that the firm is taken over and the managers are let go.

22
Q

What are dual-class shares?

A

Different classes of shares with different voting rights. Class with more generous voting rights is generally not publicly traded.

23
Q

What are ways for shareholders to influence corporate policies?

A

They can sponsor proposals, pressure the top management through the media, or engage directly.
They can also try to gain control by replacing board members, that is called a proxy fight.

24
Q

Why is the corporate governance different in family firms?

A

Because shareholders and management are the same people so there is no asymmetric information.

25
Q

Learn the slides for the research papers.

A
26
Q

When is a board member independent?

A

For listed companies, a certain number of board members has to be independent.
They are independent if they do not receive other compensation outside of board fees.
They never worked for the company.
They have never done services like auditing for the firm.
They have no other close links to the company.
They have no conflict with the company.

27
Q

What are three sources of endogeneity?

A

Reverse causality
Omitted variable
Measurement error

28
Q

What is endogeneity?

A

An effect but no causality

29
Q

In the example of how luck influences ceo compensation, describe the instrumental variable approach.

A

We are measuring how performance influences CEO compensation but luck and skill are both in performance. Therefore, we need an instrument variable that is positively correlated with luck but independent from effort. We then regress performance on this luck proxy and then CEO compensation on this luck proxy.

30
Q

How to measure good governance?

A

check number of antitakeover protections

31
Q

What are two requirements for an instrument variable?

A

it needs to be correlated with the endogenous variable but it needs to be correlated with the dependent variable only through the endogenous variable