1 2 Corporate Governance, Public Companies And Agency Costs

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Prof. Marco Bigelli - DSA - Università di Bologna

Corporate governanceAgency-Costs from separation of ownership and control:

internal and external solutions

Marco Bigelli

Department of ManagementUniversity of Bologna


Agenda

Corporate governance modelsAgency costs from separation of ownership and

controlExternal solutions

Mkt for preoducts, for managersMkt for corporate control

Internal solutionsBoardDebtIncentive schemesMonitoring

US scandalsReferences

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Corporate governance models

United States

Great Britain

Germany

Japan

Continental European countries

Mktoriented(arm’s length

based)

Bank

Oriented(relationship-

based)


Corporate governance models

BanksKeiretsuCross-ownership

Japan

Banks (big comp.), Family (smallcomp.)

Large shareholderGermany

Small shareh.Institut. investors

Public companyUS, UK

ShareholdersTypical form of control

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Germany(Franks-Mayer, RFS 01)

Universal bankMajor shareholders

Other companiesFamiliesBanks

Banks major voteholder thanks to proxiesOutsiders attempt to take control by seeking to

acquire one or more block of shares (Jenkinson and Ljungqvist JCF ’01)

There were only 4 hostile takeovers of German firmsin the second half of the 20th century

EU takeover directive transplanted in a way to protectGerman companies from hostile takeovers

M1


…Germany

Universal Bank(Shares + proxies)

Diapositiva 5

M1 Marco; 26/02/2007

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Japan

KeiretsuFinancial Institutions are the most

important blockholder (Prowse JF ’92)Internal capital marketsLong term relationshipsNo mkt myopia (high R&D)


Japan

- Keiretsu: network of companies with a main bank

- bank debt / few bond issues (forbidden till ‘80s)

Advantages:

- internal capital market

- soft solutions for financialdistress

Disadvantages:

-No mkt for corporate control

-Banks risk to go broken

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US and UK

Managers own only 2-3% of company sharesMutual and pension funds “vote with their feet”Focus on mkt price and short-term results

Mkt myopia (Stein JPE ’88; QJE ‘89)Lower R&D expenses

Agency costs of separation of ownership fromcontrol. Management versus shareholders

Public company


Agency Theory

Agency contract:

A Principal (shareholders) hire an Agent (managers) in order to act in their

interests (max shareholders’ value)But:

discretionary behaviour

asimmetric information

asimmetric distribution of results

Disallignement of interests

Agency costs

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Agency costs from separation of ownership and control: seminal studies

Smith (1776)Berle and Means (1932)Jensen and Meckling (1976)

Agency costs of debt and equityAgency costs of equity due to the

separation of ownership and controlAgency costs affect firm’ value:

Monitoring costsBonding costsResidual loss (perquisites, private benefits)


Agency costs and alignement of interests

allignement of interests (JM, 76)

0 0.2 0.4 0.6 0.8 1

alfa

Q

Managers own 100%

The higher is the managers’ ownership the higher is the allignement of interests between

shareholders and managers

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Internal and external solutionsagainst agency costs

Agency costs => efficiency

mkt for products

mkt for managers

mkt for corporate control

Board of directors

Debt and Agency costs from FCF

Incentive schemes

Active institutional investors

External

Internal


Mkt for products (Hart,83):no if monopoly (Bill Gates), closed economy (US&J)Too late!!!

Mkt manageriale (Alchian Demsetz, AER ‘72)Fama (‘80): reputational capital

efficient mkts => value = stock priceActive board (internal competition, non-executive dir.)

Bad managers removed

• No easy to remove high managers• The higher the position the older the age•Board not enough active

Mkt for products and for managers

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Mkt for corporate control

Manne ( JPE ‘65), Jensen Ruback (JFE ‘83)pubblic companyefficient mkts

Agency costs => Price down

M&A 80s (Jensen, 93):$ 2.6 trillion

Avg premium paid: 41%750 billion $ value creation

(Wall street movie)

MSV(89): Lowperformance

(active board . or M&A)

poison pills, antitakeover laws

Case: RJR Nabisco


0 0.2 0.4 0.6 0.8 1

alfa

Q

Max (5%)

Min (25-30%)

Entrenchment - FJ(JLE,83) / MSV(JFE,88)

Threat of a takerover and firm’s efficiency (Entrenchment theory)

Is ownership structure to influenceperformance or the reverse?

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Board of directors

A good corporate governance model should removebad managers?

Empirical studies on executive turnover and performance:Weisbach (JFE ’88): last decile 6% probability to be removedJensen-Murphy (JPE’90), Volpin (JFE ’02)

Evidence of negative relation between board size and firmperformance

Does the board monitor managers?Often CEO = Chairman

CEO appoints directors and make the discussion listMost directors are not independent


Two tiered boards

Two tiered board: A managing boardA supervisory board (in Germany, representation of

employees is mandatory)A two-tiered board is mandatory in some

countries: Germany, AustriaA two-tiered board is optional in other

countries: France, Finland and Italy (from the Vietti reform 2004)

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Codes of best practice

Comply or explain ruleThey usually regulate:

Board composition and roles:Definition of executive, non executive and independent directorLead independent directors and at least 1 meeting with only

independent directors alone in the Italian CodeChairman different from CEOFull disclosure on related party transactions

Internal control systemHow directors and auditors should be nominatedInternal committees

i.e. Remuneration committee (staffed with outside directors)


First Codes of best practice

UK: Cadbury report (1992)France: Vienot report (1995)Italy: Preda code (1998)Netherlands: Peters report (1997)Spain: Olivencias report (1998)Belgium: Cardon report (1998)Greece and Portugal: 1999Finland and Germany: 2000Denmark 2001Austria: 2002

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FCF hypothesis (Jensen, AER86)

Managers “waste money” when high FCF and few profitable investment opportunities (mature industries)

LBOsStrip financingIncentive schemes

Value creation through minimization of agency costs through debt and more

optimal contracts

DEBT and Free Cash Flows


Incentive schemesStock optionsEVA

EVA = (R-WACC) Invested Capital

Bonuses on accounting measuresFew incentives in the past:

In US +1000 of value creation = +2.59 in the CEO’s pocket (Jensen-Murphy ’90)

Mean CEO stake = 0,66%

Growing sensitivity of executive pay to performanceIn 1994 2 to 10 times higher than in 1980Stock option fastest growing componentMurphy ’99 Core-Guay-Larcher (RFE ‘01)Self dealing and high pays also when stock prices

plummeted (“reward for failure”)

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CEO PAY

Ratio of average CEO total pay ( includingoptions valuated at grant-date) to average

annual earnings of production workers

Ratio of average CEO’s salary and bonusTo average annual earnings of

production workers

Dow JonesIndustrials average


Incentive schemes

Source: B.J.Hall and K.J. Murphy 2000

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Incentive schemes


Stock options

Strike priceMostly at the money

Vesting periodMore firm’s lojalty

Save costs and cashBetter economic margins and eps

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Stock options: shortcomes

Manager become risk loverHigh gains no lossesWrong premia!

Always gain in a bullish stock market neverin a bearish one!

Stock mkt and industry performance shouldbe taken out, by accordingly modifying the strike price


Stock options: shortcomes

Earnings illusionFuture EPS dilution if stock is issued below mkt

priceIn US they now must be considered as a cost to

the firmFraudolent behaviour

Do whatever possible to keep stock price up tillthe end of the vesting period (Enron)

Bribe analystsBribe auditors“Cook the books”

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Stock options and fraudolent behaviour


Enron and insiders’ sales before the crash

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The perfect payday for Eads’ Ceo

Delay announced in the A380 superjumbo

programme

Noël Forgeard (co-CEO):2.5 million € profit on

the options exercise and sell off

32,01

Ex.price: 15,65-16,96


BackdatingBackdating allows executives to choose a past date when the market price was particularly low, thereby

inflating the value of the options.

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Analist advises …

Recent studies have found that if you follow analyst advise you

underperform the mkt.

You beat the market if you do the opposite of what they advise to do!


Monitoring and active investors

Free ridingLeland-Pyle (JF ’77) Grossman-Hart (BJE ‘80)

Delegated MonitoringBanks (Diamond, RES ’84), Stakeholders (Schleifer and Vishny, JPE ‘86)

Monitoring and institutional investorsVote with their feetMore activism needed (Jensen JF ’93)

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Active investors: the Glaxo case

GlaxoSmithKline (2003)Board proposes high management compensation scheme.$36 million golden parachute for Garnier (CEO )Shareholder meeting vote against!

51% voting shareholderInstitutional investors against “reward for failure”

Other cases (2003):Reuters (22%), Shell (23%), HSBC (14%)

Nowadays there are “activists” hedge funds (seeHermes and Amber for ex.)


Hermes UK Focus Fund Investment Process

Becht, Mayer, Franks and Rossi, ECGI WP 136/2006

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Hermes UK Focus Fund Engagement Process

Becht, Mayer, Franks and Rossi, ECGI WP 136/2006


Us Scandals

–Enron, Worldcom, Global Crossing–Large equity price rises in late 1990’s created incentives to pump up firm value, cash in the options, and run

•thus there was a huge increase in expected value to value increasing activity and no change in the expected punishment

–little evidence of SEC enforcement of securities laws –Boards and Shareholders didn’t care if stock price kept going up

»The result was an increase in aggressive actions to increase value of firm

•including illegal actions

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•In 2000 stock prices fell sharply »with lower prices many activities to inflate value collapsed

»others were pressed harder to do things to keep value up –suddenly we were questioning how these activities could have gone on –blame all around

»complicity between management and auditors in reporting information to shareholders

•auditor had incentive to keep firms happy as they made more money on consulting services than auditing

»boards of directors that were too friendly to management and or caring only of insiders not outsiders

•lack of independence and effort on the part of boards

Where was the Governance?


US Response

•The US has seen a marked increase in attention to corporate governance issues

»reduced reliance on options and discussion of appropriate reporting

•Microsoft now to use restricted stock rather than options •SEC discussing appropriate charge to income for options

–options are valuable even when issued out of the money

»Legislation: Sarbanes - Oxley 2002

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Some references

Alchian A. A. e H. Demsetz (1972), “Production, Information Costs, and Economic Organization” in American Economic Review, vol. 62, pp.777-795.

Berle A. e G. Means (1932), The Modern Corporation and Private Property, Transaction Publishers, New Yersey, 1991; ed. it.: Società per azioni e proprietà privata, Einaudi, Torino, 1966.

Diamond D. W. (1984), “Financial Intermediation and Delegated Monitoring”in Review of Economic Studies, pp. 393-414.

Fama E. (1980), “Agency Problems and the Theory of the Firm” in Journal of Political Economy, vol. 88, n.2, pp. 288-307.

Fama E. e M. C. Jensen (1983), “Separation of Ownership and Control” in Journal of Law and Economics, vol. 26, giugno, pp. 301-325.

Grossman S. J. e O. D. Hart (1980), “Takeover Bids, the Free-Rider Problem and the Theory of the Corporation” in Bell Journal of Economics, n. 11, pp. 42-64.

Jensen M. e W. Meckling (1976), “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure” in Journal of Financial Economics, vol. 3, pp. 305-360.

Jensen M. C. (1986), “Agency Costs of Free Cash Flows, Corporate Finance and Takeovers” in American Economic Review, settembre-ottobre, pp. 305-360.

Jensen M. C. e K. J. Murphy (1990a), “CEO Incentives - It’s Not How Much You Pay, But How” in Harvard Business Review, maggio-giugno, pp.138-153.


References

Jensen M. C. e K. J. Murphy (1990b), “Performance Pay and Top-Management Incentives” in Journal of Political Economy, n. 98, pp. 225-264.

Leland H. E. e D. H. Pyle (1977), "Informational Asymmetries, Financial Structure, and Financial Intermediation" in Journal of Finance, vol. 32, n. 2, pp. 370-387.

Manne H. G. (1965), “Mergers and the Market for Corporate Control” in Journal of Political Economy, vol. 73, n. 4, pp. 110-120.

Morck R., A. Shleifer e R. W. Vishny (1988), “Management Ownership and Market Valuation: An Empirical Analysis” in Journal of Financial Economics, vol. 20, pp. 293-315.

Sahlman W. A. (1990), “Why Sane People Shouldn’t Serve on Public Boards” in Harvard Business Review, maggio-giugno, pp. 28-35.

Shleifer A. e Vishny R. W. (1986), “Large Shareholders and Corporate Control” in Journal of Political Economy, n. 94, pp. 461-488.

Smith A. (1937), The Wealth of Nations, Cannan Edition, Modern Library, New York, trad. it., La ricchezza delle nazioni, ISEDI, Milano, 1973.

Weisbach M. S. (1988), “Outside Directors and CEO Turnover” in Journal of Financial Economics, vol. 20, pp. 431-460.

1 2 Corporate Governance, Public Companies And Agency Costs

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