1 2 Corporate Governance, Public Companies And Agency Costs

Corporate governance
Agency-Costs from separation of ownership and control:
internal and external solutions

Marco Bigelli

Department of Management
University of Bologna

Prof. Marco Bigelli - DSA - Università di Bologna

Agenda
Corporate governance models
Agency costs from separation of ownership and
control
External solutions
Mkt for preoducts, for managers
Mkt for corporate control
Internal solutions
Board
Debt
Incentive schemes
Monitoring
US scandals
References


1


United States
Mkt
Great Britain
oriented
(arm’s length
based)

Germany
Bank Japan
Oriented Continental European countries
(relationship-
based)



Typical form of Shareholders
control
US, UK Public company Small shareh.
Institut.
investors
Large shareholder Banks (big comp.),
Germany
Family (small
comp.)
Japan Keiretsu Banks
Cross-ownership


2

M1

Germany
(Franks-Mayer, RFS 01)

Universal bank
Major shareholders
Other companies
Families
Banks
Banks major voteholder thanks to proxies
Outsiders 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 firms
in the second half of the 20th century
EU takeover directive transplanted in a way to protect
German companies from hostile takeovers


…Germany

Universal Bank
(Shares + proxies)


3

Diapositiva 5

M1 Marco; 26/02/2007

Japan

Keiretsu
Financial Institutions are the most
important blockholder (Prowse JF ’92)
Internal capital markets
Long term relationships
No mkt myopia (high R&D)


Japan

- Keiretsu: network of companies with a main bank
- bank debt / few bond issues (forbidden till ‘80s)
Advantages:
Disadvantages:
- internal capital market
-No mkt for corporate control
- soft solutions for financial
-Banks risk to go broken
distress

4

US and UK

Public company
Managers own only 2-3% of company shares
Mutual 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 from
control. Management versus shareholders


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

5

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 equity
Agency costs of equity due to the
separation of ownership and control
Agency costs affect firm’ value:
Monitoring costs
Bonding costs
Residual loss (perquisites, private benefits)


Agency costs and alignement of interests
The higher is the managers’ ownership the higher
is the allignement of interests between
shareholders and managers
allignement of interests (JM, 76)

Q

Managers own
100%

0 0.2 0.4 0.6 0.8 1

alfa


6

Internal and external solutions
against agency costs

Agency costs => efficiency

mkt for products
External mkt for managers
mkt for corporate control

Board of directors
Debt and Agency costs from FCF
Internal
Incentive schemes
Active institutional investors


Mkt for products and for managers

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 price
Active 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

7

Mkt for corporate control
Manne ( JPE ‘65), Jensen Ruback (JFE ‘83)
Agency costs => Price down
pubblic company
efficient mkts

MSV(89): Low
performance
(active board . or
M&A 80s (Jensen, 93):
M&A)
$ 2.6 trillion
Avg premium paid: 41%
750 billion $ value creation
Case: RJR
Nabisco
(Wall street movie)

poison pills, antitakeover laws


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

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

Q

)
%) 0%
x (5 5-3
Ma n (2
Mi

0 0.2 0.4 0.6 0.8 1

alfa

Is ownership structure to influence
performance or the reverse?


8

Board of directors

A good corporate governance model should remove
bad managers?
Empirical studies on executive turnover and performance:
Weisbach (JFE ’88): last decile 6% probability to be removed
Jensen-Murphy (JPE’90),
Volpin (JFE ’02)
Evidence of negative relation between board size and firm
performance
Does the board monitor managers?
Often CEO = Chairman
CEO appoints directors and make the discussion list
Most directors are not independent

Two tiered boards

Two tiered board:
A managing board
A supervisory board (in Germany, representation of
employees is mandatory)
A two-tiered board is mandatory in some
countries: Germany, Austria
A two-tiered board is optional in other
countries: France, Finland and Italy (from the
Vietti reform 2004)


9

Codes of best practice

Comply or explain rule
They usually regulate:
Board composition and roles:
Definition of executive, non executive and independent director
Lead independent directors and at least 1 meeting with only
independent directors alone in the Italian Code
Chairman different from CEO
Full disclosure on related party transactions
Internal control system
How directors and auditors should be nominated
Internal 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: 1999
Finland and Germany: 2000
Denmark 2001
Austria: 2002

10

DEBT and Free Cash Flows

FCF hypothesis
(Jensen, AER86)

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

Value creation through minimization of
agency costs through debt and more
optimal contracts

LBOs
Strip financing
Incentive schemes

Incentive schemes
Stock options
EVA
EVA = (R-WACC) Invested Capital
Bonuses on accounting measures
Few 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 performance
In 1994 2 to 10 times higher than in 1980
Stock option fastest growing component
Murphy ’99 Core-Guay-Larcher (RFE ‘01)
Self dealing and high pays also when stock prices
plummeted (“reward for failure”)

11

CEO PAY

Dow Jones
Ratio of average CEO total pay ( including Industrials average
options valuated at grant-date) to average
annual earnings of production workers

Ratio of average CEO’s salary and bonus
To average annual earnings of
production workers


Incentive schemes

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


12

Incentive schemes


Stock options

Strike price
Mostly at the money
Vesting period
More firm’s lojalty
Save costs and cash
Better economic margins and eps


13

Stock options: shortcomes

Manager become risk lover
High gains no losses
Wrong premia!
Always gain in a bullish stock market never
in a bearish one!
Stock mkt and industry performance should
be taken out, by accordingly modifying the
strike price


Stock options: shortcomes

Earnings illusion
Future EPS dilution if stock is issued below mkt
price
In US they now must be considered as a cost to
the firm
Fraudolent behaviour
Do whatever possible to keep stock price up till
the end of the vesting period (Enron)
Bribe analysts
Bribe auditors
“Cook the books”


14

Stock options and fraudolent behaviour


Enron and insiders’ sales before the crash


15

The perfect payday for Eads’ Ceo

32,01

Noël Forgeard (co-CEO):
Delay announced in
2.5 million € profit on
the A380 superjumbo
the options exercise and
programme
sell off

Ex.price: 15,65-16,96


Backdating
Backdating allows executives to choose a past date
when the market price was particularly low, thereby
inflating the value of the options.


16

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 riding
Leland-Pyle (JF ’77) Grossman-Hart (BJE ‘80)
Delegated Monitoring
Banks (Diamond, RES ’84),
Stakeholders (Schleifer and Vishny, JPE ‘86)
Monitoring and institutional investors
Vote with their feet
More activism needed (Jensen JF ’93)


17

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 shareholder
Institutional investors against “reward for failure”
Other cases (2003):
Reuters (22%), Shell (23%), HSBC (14%)
Nowadays there are “activists” hedge funds (see
Hermes and Amber for ex.)


Hermes UK Focus Fund Investment Process

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


18

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


19

Where was the Governance?

•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


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


20

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), quot;Informational Asymmetries, Financial
Structure, and Financial Intermediationquot; 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.


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