1-2 Corporate Governance, Public Companies and Agency Costs

Corporate governance
AgencyAgency -Costs from separation of ownership and control: internal and external solutions
Marco Bigelli Department of Management University of Bologna
Prof. Marco Bigelli - University of Bologna
Agenda
Corporate governance models Agency costs from separation of ownership and control External solutions
Mkt for products, for managers Mkt for corporate control
Internal solutions
Board Debt Incentive schemes Monitoring
US scandals References
Corporate governance models

United States Mkt oriented
(arms length based)
Great Britain
Germany Bank Oriented

(relationshipbased)
Japan Continental European countries
Corporate governance models

Typical form of control Shareholders US, UK Public company Small shareholders Institutional investors
Banks (big comp.), Family (small comp.)
Germany Japan
Large shareholder Keiretsu Cross-ownership
Banks
M1
Germany
(Franks-Mayer, RFS 01)
Universal bank Major shareholders Other companies Families Banks Banks major vote-holder 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)
Diapositiva 5 M1
Marco, 26/02/2007
Japan
Keiretsu: network of companies with a main bank
Japan
Financial Institutions are the most important block-holder (Prowse JF 92) Internal capital markets Long term relationships and no mkt myopia (high R&D)
Advantages: - internal capital market - soft solutions for financial distress

Disadvantages: -No mkt for corporate control -Banks risk to go broken
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 behavior asymmetric information asymmetric distribution of results
Disallignement of interests Agency costs

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 alignment of interests

The higher is the managers ownership the higher is the alignment of interests between shareholders and managers Hence, JM expects a linear relationship between managerial ownerhip (alfa) and firms performance (measured by Tobins Q)
alignment of interests (JM, 76)
Q
Managers own 100%
0.2
0.4
0.6
0.8
1 alfa
Internal and external solutions for reducing agency costs from O/C separation
Agency costs =>
efficiency
mkt for products External Solutions mkt for managers mkt for corporate control Board of directors Internal Solutions Debt and Agency costs from FCF Incentive schemes Active institutional investors
Market for products and Market for managers
Mkt for products

Inefficient companies will progressively have a lower market share and will eventually be out of the market (Hart,83) Even when it works, its action comes too late, when all wealth has been destroyed and efficiency cant be restored It does not work in case of monopolies
Italian Ferrovie dello Stato or Rai
It does not work in close economies
Mkt for managers

Mkt for managers (Alchian Demsetz, AER 72)
Fama (80): managers have reputational capital efficient mkts => bad performance => lower stock price Active board in removing bad managers (needed internal competition, non-executive directors, etc.)
Bad managers removed Actually, this force is not too effective as:
No easy to remove high managers The higher the position the older the age (reputation effect less important) Board not enough active
Market for Corporate Control
Mkt for corporate control

Manne ( JPE 65), Jensen Ruback (JFE 83)
public company efficient mrkets
MSV(89): Low performance (active board . or M&A) Agency costs => Price down
M&A 80s (Jensen, 93):

$ 2.6 trillion Avg premium paid: 41% 750 billion $ value creation
Case: RJR Nabisco poison pills, antitakeover laws
Entrenchment theory
The threat of a takeover may induce managers to be more efficient not to risk to be taken over and removed For higher values of managerial ownership managers become more entrenched and difficult to be removed (for alfa > 25%, hostile takeovers were never successful). The relationship between firms efficiency and managerial ownership may not be monotonic (Fama Jensen 1983) since: Agency costs depend on two forces:
Alignment of interests Managerial entrenchment
Empirical evidence on firms performance and managerial ownership

Entrenchment - FJ(JLE,83) / MSV(JFE,88)
Q
0.2
0.4
0.6
0.8
1 alfa
However, is ownership structure to influence performance or the reverse?
10
The board of directors
Internal solution: effective functioning of the 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 (JPE90), Volpin (JFE 02)
Few significant evidence on boards: only a 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
11
Stated reasons for CEOs Turnover
Examples of CEO Succession cases
12
Two tiered boards in some countries

Two tiered board:
A managing board A supervisory board (in Germany, a 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) In Italian listed companies such structure has been adopted especially in banks after major mergers (For ex., Intesa,Unicredit)
Boards and 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)
13
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
Internal committes in US S&P 500 firms
14
The disciplining role of debt (and its abuses)
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
15
LBOs and Private Equity Funds
The Private Equity Bubble
16
The Private Equity Bubble
Much more leverage than before
17
Low credit spreads help high leverages
Higher leverage allow higher prices in acquisitions
18
Incentive scheme and stock options (and its abuses)
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 CEOs 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)
19
CEO PAY
Ratio of average CEO total pay ( including options valuated at grant-date) to average annual earnings of production workers
Dow Jones Industrials average
Ratio of average CEOs salary and bonus To average annual earnings of production workers
Incentive schemes
Source: B.J.Hall and K.J. Murphy 2000
20
Incentive schemes
Stock options
Strike price
Mostly at the money
Vesting period: 2-3 year

During such period stock options cannot be either sold or exercised It increases managers loyalty to the firm
Stock options allow to save costs and cash

Better economic margins and EPS Greatly used by .com firms
21
Stock options: shortcomes

High gains no losses Manager become risk lover 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
22
Cook the books

Definition = Financial statements falsification Reasons to cook the books: Meet shareholders expectations Attract investors Maintain stock value Raise debt
Executives remunerations based on earnings or stock options

Cook the books

Some ways to cook the books:
Off balance sheet accounting SPEs Expense Manipulation Pension plan manipulation Bribery
23
Stock options and fraudolent behaviour
Enron and insiders sales before the crash
24
The perfect payday for Eads Ceo
32,01
Nol Forgeard (co(co-CEO): 2.5 million profit on the options exercise and sell off Ex.price: 15,6515,65-16,96
Delay announced in the A380 superjumbo programme
A recent case: Richard Fuld

Starts his career in Lehman in 1969 as an intern 25 years later, in 1994, he becomes CEO From 1994 to 2007, he is reported to have received nearly $500 mln in total compensation
25
Fulds compensation structure
Performance based compensation of Richard Fuld [2000-2008] Salary & other Cash bonus compensation 2000 2001 2002 2003 2004 2005 2006 2007 Total
763,710 762,517 763,008 764,439 766,028 767,791 939,585 903,169 6,430,247 8,800,000 4,000,000 1,100,000 6,700,000 10,300,000 13,800,000 6,800,000 4,300,000 55,800,000
Option exercice
43,000,000 93,600,000 21,100,000 37,500,000 13,900,000 75,000,000 31,900,000 40,300,000 356,300,000
Stock sales
67,100,000 67,100,000
Total
52,563,710 98,362,517 22,963,008 44,964,439 24,966,028 89,567,791 106,739,585 45,503,169 485,630,247
Lehmans case: performance-based compensation

Compensation design is linked to risky decisions Compensation design is not linked to risky decisions
Performance-based compensation did not produce an alignment with long-term shareholders value maximization This scheme provided Fuld with incentives to seek improved short-term results even at the cost of maintaining an excessively risky positions
Fuld suffered large losses when Lehman collapsed His risk-taking decisions were due to his failure to perceive risks and overall an extralarge ego, in fact, until September 15 he refused to acknowledge Lehman was in trouble
26
Lehman compensation pushed Fuld to take risky decisions
30,4x vs. 15x in commercial banks
Richard Fuld vs. US House Committee on Oversight and Government Reform
27
Major novelties from the Dodd-Frank Act (July 2010)

Vote on Executive Pay and Golden Parachutes: Gives shareholders a say on pay with the right to a non-binding vote on executive pay and golden parachutes. This gives shareholders a chance to disapprove where they see the kind of misguided incentive schemes. No Compensation for Lies: Requires that public companies set policies to take back executive compensation if it was based on inaccurate financial statements that dont comply with accounting standards. SEC Review: Directs the SEC to clarify disclosures relating to compensation, including requiring companies to provide charts that compare their executive compensation with stock performance over a five-year period.
Major novelties from the Dodd-Frank Act (July 2010)

Independent Compensation Committees: Standards for listing on an exchange will require that compensation committees include only independent directors and have authority to hire compensation consultants in order to strengthen their independence from the executives they are rewarding or punishing. Enhanced Compensation Oversight for Financial Industry: Requires Federal financial regulators to issue and enforce joint compensation rules specifically applicable to financial institutions with a Federal regulator.
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Backdating
Backdating allows executives to choose a past date when the market price was particularly low, thereby inflating the value of the options.
Backdating
29
Backdating
Around 29 % of options were backdated from 1992 to 2002 80 investigations led by SEC in 2006
POSSIBLE SOLUTIONS:
High penalties for not reporting the grants of stock options within 2 days Obligation to grant stock options on the same day every year. But in this case there will still be possibility of timing of bad-good news
Analysts advises
30
Analysts 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
31
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)
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.)
32
Hermes UK Focus Fund Investment Process
Becht, Mayer, Franks and Rossi, ECGI WP 136/2006 Prof. Marco Bigelli - University of Bologna
Hermes UK Focus Fund Engagement Process
Becht, Mayer, Franks and Rossi, ECGI WP 136/2006 Prof. Marco Bigelli - University of Bologna
33
Activist in Italian listed companies at April 15th 2009
Source: Erede 2009
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.: Societ per azioni e propriet 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. 305360. Jensen M. C. e K. J. Murphy (1990a), CEO Incentives - Its Not How Much You Pay, But How in Harvard Business Review, maggio-giugno, pp.138-153.
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Some references
Jensen M. C. e K. J. Murphy (1990b), Performance Pay and TopManagement 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 Shouldnt 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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Corporate governance

Marco Bigelli Department of Management University of Bologna

Prof. Marco Bigelli - University of Bologna

Corporate governance models

Germany Bank Oriented

Japan Continental European countries

Prof. Marco Bigelli - University of Bologna

Corporate governance models

Large shareholder Keiretsu Cross-ownership

Prof. Marco Bigelli - University of Bologna

Prof. Marco Bigelli - University of Bologna

Prof. Marco Bigelli - University of Bologna

Advantages: - internal capital market - soft solutions for financial distress

Disadvantages: -No mkt for corporate control -Banks risk to go broken

Agency costs of separation of ownership from control. Management versus shareholders

Prof. Marco Bigelli - University of Bologna

Disallignement of interests Agency costs

Agency costs from separation of ownership and control: seminal studies

Prof. Marco Bigelli - University of Bologna

Agency costs and alignment of interests

Managers own 100%

Prof. Marco Bigelli - University of Bologna

Agency costs =>

Prof. Marco Bigelli - University of Bologna

Market for products and Market for managers

Prof. Marco Bigelli - University of Bologna

Mkt for products

It does not work in close economies

Prof. Marco Bigelli - University of Bologna

Mkt for managers

Market for Corporate Control

Prof. Marco Bigelli - University of Bologna

Mkt for corporate control

M&A 80s (Jensen, 93):

Prof. Marco Bigelli - University of Bologna

Empirical evidence on firms performance and managerial ownership

However, is ownership structure to influence performance or the reverse?

Prof. Marco Bigelli - University of Bologna

The board of directors

Prof. Marco Bigelli - University of Bologna

Internal solution: effective functioning of the board of directors

Does the board monitor managers?

Stated reasons for CEOs Turnover

Prof. Marco Bigelli - University of Bologna

Examples of CEO Succession cases

Prof. Marco Bigelli - University of Bologna

Two tiered boards in some countries

Boards and Codes of best practice

First Codes of best practice

Internal committes in US S&P 500 firms

Prof. Marco Bigelli - University of Bologna

The disciplining role of debt (and its abuses)

Prof. Marco Bigelli - University of Bologna

DEBT and Free Cash Flows

LBOs and Private Equity Funds

Prof. Marco Bigelli - University of Bologna

The Private Equity Bubble

Prof. Marco Bigelli - University of Bologna

The Private Equity Bubble

Prof. Marco Bigelli - University of Bologna

Much more leverage than before

Prof. Marco Bigelli - University of Bologna

Low credit spreads help high leverages

Prof. Marco Bigelli - University of Bologna