2010

Lecture 1: Separation of ownership and management. The Fall of Enron: In 2000 its per share stock price was $90. A few months later it fall to 61 cents. Senior managers behaved in an unethical manner. They mislead shareholders and employees about the true state of the companys performance. They created high financial performance expectations for the company. They hoped that Enrons stock price would continue to rise. This gave them the opportunity to exercise stock options for substantial personal gain. More than $27 billion in off-balance-sheet debt held by partnerships hidden from the view of most investors (stockholders), creditors, employees and regulators. The partnerships were controlled by Enron managers but not owned by Enron, so the debt did not appear on Enrons balance sheets and did not affect the companys credit rating and borrowing costs. The partnerships were financed with debt raised from institutional investors. Using the companys stock as collateral, Enron guaranteed that debt. The role of Arthur Andersen, Enrons auditor. Corporate Governance relates to the ways in which the suppliers of finance to corporations assure themselves of getting a return on their investment. That is, Corporate Governance provides tools that can be put in place to make sure that the interests of the shareholders are recognized and incorporated into the strategy making process. The perceived quality of a company's corporate governance can influence its share price as well as the cost of raising capital. Quality: Is determined by the financial markets, legislation and other external market forces plus how policies and processes are implemented and how people are led. The companys value: A pie divided among a number of claimants: Management and shareholders Workforce Banks and investors (they have bought the companys debt) Goverment (taxes on corporate profits)

Example. Managers can serve the interests of shareholders by investing in projects with the highest positive NPV. Advantages: Ownership can change without interfering with the operation of the business. Firm can hire professional managers. Disadvantages (Moral Hazard): Managers may not want to maximize the value of the firm but their own income. (i) Managers may put insufficient effort (allocation of work time to various tasks) (ii) Extravagant investments to improve their image. I.e. unnecessary acquisitions (when buying oil was cheaper than obtaining it by drilling it). (iii) Managers may take actions that hurt shareholders in order to keep or secure their position. I.e. they might want to invest in declining industries that they know how to run. Managers may engage in excessive or insufficient risk. Resist hostile akeovers when these threaten their position. (iv) Managers may consume perks (costly private jets etc). Select a costly supplier on friendship grounds, finance political parties. Corporate governance may be dysfunctional when: There is lack of transparency. I.e. Investors and other shareholders are sometimes imperfectly informed about the levels of compensation and other perks granted to top managers. The total compensation packages (salary plus bonus) to top executives has risen substantially over the years: The average CEO compensation has tripled between 1980 and 1994 for large US corporations. Tenuous link between performance and compensation. High levels of compensation may not be related to performance but to exogenous factors. Compensation rarely decreases despite poor performance. Accounting manipulations: Manipulations that inflate companys performance. Manipulations may increase earnings and thus the value of management compensation. I.e. Managers with option packages may find it attractive to inflate earnings.

Managerial Incentives. Explicit and implicit incentives partly align managerial incentives with the firms interests. These are: Explicit incentives: Monetary package (salary, bonus, stock based incentives: stock and stock options) induce managers to internalize the owners interests. Implicit incentives: The threat of being fired by the board of directors or removed through a takeover.

Bonus: Depend on current (accounting data on) profits, short term [these may be manipulated]. Shareholdings: Depend on the value of shares, long term [are subject to exogenous factors creating volatility]. Bonus and Shareholdings are complements [should move to the same direction]. The compensation base should not be based on factors outside the control of the manager. I.e. fluctuations in interest rater, exchange rate etc. Compensation should be based on the relative performance of the firm (with respect to similar companies). Straight shares or stock options? Stock options: The right to purchase at a specified date stocks at some exercise price: call options [the options are valueless if the market price is below the exercise price]. Straight shares: The manager internalizes shareholder value over the whole range of market prices and not only above the exercise price.

[The buyer of a call option has the right, but not the obligation to buy an agreed quantity of a particular stock from the seller of the option at a certain time for a certain price]. Managers prefer shares (they are risk averse). Shares provide managers with a rent even when their performance is poor. [Figure 1.1. (a) on page 24] On the other hand, suppose that a manager is given stock options to be exercised after two years. If the firm faces an adverse shock in the first year, that makes the exercise of the option unlike, the manager may take substantial risks to increase the value of his stocks.

Implicit incentives Managers will loose their job if their performance is poor.

Poor performance may lead to a takeover. Possibility of bankruptcy and reorganization.

Implicit incentives are over and above explicit incentives. Implicit incentives and explicit incentives are substitutes. With stronger implicit incentives, fewer stocks and stock options are needed to curb managerial moral hazard. We have agency costs. Shareholders: Want to increase the value of the firm. They want to monitor managers and influence their actions. The principal-agent problem is the result of information asymmetries. Monitoring: Monitoring of corporations is done by: The board of directors, shareholders, large creditors, investment banks rating agencies etc. Active monitoring: Interfere with management (and exercise control rights) to increase the value of the investors claims (NPV). I.e. A large shareholder may sit on the board and intervene on the policies proposed by the management. It is forward looking (for decisions that affect the future). Speculative monitoring: It is backward looking (it does not attempt to increase firms value but to measure the value of the firm). It depends on past and current actions of management. A stock market analyst studies firms in order to maximize portfolio return without intervening with firms management. Monitors interfere with management on behalf of shareholders. Approve major business decisions and corporate strategy: Disposal of assets, investments or acquisitions. In charge of executive compensation etc. Offer advices to management. Product-Market competition. The quality of a firms management depends on both its design of corporate governance and on the firms competitive environment. When there is competition it is easier to measure he relative performance of the management. With competition managers should try to take advantage of any favorable development in the market as they want to perform better than their competitors. Thus, product-market competition improves management performance. The board of Directors.

Board members are directly elected by stock-holders and under corporate law they represent the stockholders interests in the company. A board of directors is a mix of inside and outside directors. Inside directors are senior employees of the company. They are well informed about the companys activities. As employees, their interests are aligned with those of management.

Disadvantages of board of directors. Lack of independence. Independent directors are not linked with the company. However, usually they have personal connections with the managers. Insufficient attention. Outside directors are very busy, and they do not have time to prepare for the meetings. Insufficient incentives. There is a weak link between firm performance and directors compensation. Avoidance of conflicts. They avoid to confront management. The relation between directors and managers breaks down mainly during crises. In general decreases in the share price lead to an increase in board activity as measured by the annual number of board meetings.

Investor activism. Active monitors intervene in firms strategic decisions like: Investments, asset sales, managerial compensation, board size and composition. Active monitors must have control. Control may be formal or real. Formal control have: Majority shareholders, venture capitals etc. It allows large owners to directly implement the changes they find necessary. Real control have: Minority owners who persuade other owners of the need for intervention. In a proxy contest shareholders unhappy with management policies seek either election to the board of directors with the ultimate goal of removing management or support by a majority of shareholders for a resolution on a specific corporate policy. Sometimes, the threat of a proxy contest suffices to achieve the active monitors aims, and the contest need not occur.

Pattern of Ownership. Investor activism is linked to the structure of ownership. The decomposition of shareholding among the various types of investors is important as institutional investors do not have the same incentives to monitor. The limits of active monitoring Institutional investors (managers of pension and mutual funds) focus on short term profits. Also, in many cases have limited managerial competency. The active monitor does not internalize the welfare of other investors and therefore may not monitor efficiently.

Takeovers and leveraged buyouts. Usually firms with low Q ratios of market value of securities over the accounting value of assets are targets of takeover bids. A low Q (between 0 and 1) means that the cost to replace a firm's assets is greater than the value of its stock. This implies that the stock is undervalued. Refer to the market for corporate control. Takeovers may be needed to keep managers on their toes if the board of directors and the general assembly are ineffective monitors and thus traditional corporate governance fails. Problem: May induce managers to act myopically. A takeover starts as a tender offer, i.e. as an invitation to buy the firms shares at an announced price. In a tender offer the management is not opposed to the invitation to buy the firms shares at an announced price. The offer may concern part or all of the stock. It may be conditional on a certain number of shares effectively tendered (the bidder is often interested in the shares only if he obtains a controlling stake). In a hostile takeover the raider invites shareholders to accept the offer whether the board recommends it or not. The threat of takeovers may improve corporate governance. However, it may induce managers to act myopically and boost short-term performance at the expense of the long-run one. Takeovers may put in place a new management with fresh ideas and avoid past mistakes. The management may use takeover defenses (measures against a possible takeover). Leveraged Buyouts. The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of

the acquiring company. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital. In an LBO a firm is taking private by purchasing its shares and allocating them to a concentrated ownership composed of management, a general partner (an LBO specialist who brings equity of his own and finds investors to cofinance the LBO) and other investors. In an LBO there is a substantial increase of debt (as equity decreases). In such case we have: Stronger monetary incentives for the firms managers (relative to those of a publicly traded corporation) Active monitoring taking seriously as the general partner has both the incentives and the means of intervention. High leverage forces management and the partnership to work out cost reductions and improvements in efficiency. LBO targets have to generate large and steady cash flows in order to service the high debt payments. I.e. must be mature industries. The winners from takeovers: The target shareholders. Bidders neither gained nor lost. Takeovers create value. However, a raider cannot offer less than the post-acquisition value of the firm and have the target shareholders tender their shares. Takeovers in 80s Takeovers are associated with an increase in total value. They prevented some managers from wasting free cash flow, forced some exit or curtailments in excess capacity. Did not have a large negative impact on long-term investments i.e. R&D expenditures. Takeovers in 90s Led to wealth destruction

Debt as a governance Mechanism. Debt is often viewed as a disciplining device especially if its maturity is relatively short. It forces the firm to pay with cash flow. As a result, managers are not tempted to use them for themselves. There is always the fear of illiquidity. Under financial distress, but in the absence of liquidation, creditors acquire control rights over the firm (they can force the firm into bankruptcy). Debtholders are more conservative than equityholders. Therefore, they limit risk by cutting investment and new projects.

Summary We have agency costs. Shareholders: Want to increase the value of the firm. They want to monitor managers and influence their actions. Other agency costs: Between senior management and junior management. Agency costs in financing: Banks, bondholders lend the company money. Together with shareholders want company to prospect. But there are conflicts of interest. Managers want to save the firm but lenders want to get their money back, and do not want the firm to take risks that could affect the safety of their loans. The companys value: A pie divided among a number of claimants. Management and shareholders Workforce Banks and investors (they have bought the companys debt) Goverment (taxes on corporate profits) Principal principal-agent problem is the result of information asymmetries. Reference Jean Tirole, The theory of corporate finance, Princeton University Press 2006, Chapter 1.