Christo Pirinsky

2-1
FINA 3001

Corporate Governanve

Christo Pirinsky
Christo Pirinsky
2-2
The Firm
Christo Pirinsky
2-3
The Agency Problem
At one time in U.S. history, firms were owned and managed by founders and
their descendants.
As firms grew larger, they needed more capital than could easily be provided
by one person or family, and so the public corporation became more
common.

Public corporations generally separate ownership and control. Shareholders
are principals and managers are agents; an agency problem exists when
agents have incentives to act in ways that are contrary to the interests of their
principals.

Christo Pirinsky
2-4
The Agency Problem
Truth be told, I think I thrive under
a lack of accountability.
Michael Scott ("The Office")




Public corporations separate ownership and control.
Shareholders are principals and managers are agents.
An agency problem exists when agents act in ways that are contrary to
the interests of their principals

In large public corporations: a large number of ever-changing principals
dispersed shareholders

Christo Pirinsky
2-5
The Agency Problem
What makes agency problems particularly likely in public corporations is
the large number of ever-changing principals (shareholders holding their
stock for varying periods of time), all of whom would be better off if some
shareholders would monitor the firms managers.

Less monitoring of managers by shareholders than is optimal occurs
because monitoring is costly but all shareholders benefit from the actions of
the few that engage in monitoring (the free-rider problem).

How could managers extract rents from the firm?


Christo Pirinsky
2-6
How Could Managers Extract Rents from the Firm?
Under-investment


Over-investment (avoid returning capital to investors)





High compensation

Christo Pirinsky
2-7
How Could Managers Extract Rents from the Firm?
Under-investment
Low effort
Loyalty to friends in company

Over-investment (avoid returning capital to investors)
Power
Entrenchment
Loyalty to friends in company
Short-term gain

High compensation
Salary
Non-pecuniary benefits

Christo Pirinsky
2-8
Value According to Warren Buffett
A Valuable castle
Need to understand value
Complexity!?

The Duke in charge
Honest
Hardworking
Able

A moat around the castle
Customer loyalty, brand quality
Barriers to entry


http://www.youtube.com/watch?v=r7m7ifUz7r0&feature=relmfu
Christo Pirinsky
2-9
Corporate Governance
A relationship among stakeholders that is used to determine and control the
strategic direction and performance of organizations

Identifying ways to ensure that strategic decisions are made effectively
Used in corporations to establish order between the firms owners and its
top-level managers
Increased attention in recent years, due to a number of well-known
governance failures
Christo Pirinsky
2-10
The Annual Meeting as a disciplinary venue
The power of stockholders to act at annual meetings is diluted by three factors
Most small stockholders do not go to meetings because the cost of going to the
meeting exceeds the value of their holdings.
Proxy voting (some members delegate voting power to others; not allowed in the
U.S. Congress). Incumbent management starts off with a clear advantage when it
comes to the exercise of proxies. Proxies that are not voted become votes for
incumbent management!?
For large stockholders, the path of least resistance, when confronted by managers
that they do not like, is to vote with their feet (i.e. sell their holdings).


Christo Pirinsky
2-11
And institutional investors go along with incumbent
managers
Christo Pirinsky
2-12
Board of Directors as a disciplinary mechanism
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2-13
The CEO often hand-picks directors
A 1992 survey by Korn/Ferry revealed that 74% of companies relied on
recommendations from the CEO to come up with new directors; Only 16%
used an outside search firm. While that number has changed in recent years,
CEOs still determine who sits on their boards.
Directors often hold only token stakes in their companies. Most directors in
companies today still receive more compensation as directors than they gain
from their stockholdings. While share ownership is up among directors today,
they usually get these shares from the firm (rather than buy them).
Many directors are themselves CEOs of other firms. Worse still, there are
cases where CEOs sit on each others boards.
In most boards, the CEO continues to be the chair. Not surprisingly, the CEO
sets the agenda, chairs the meeting and controls the information provided to
directors.
Christo Pirinsky
2-14
Whos on Board? The Disney Experience - 1997
Calpers, the California Employees Pension fund, suggested three tests in 1997
of an independent board
Are a majority of the directors outside directors?
Is the chairman of the board independent of the company (and not the CEO of the
company)?
Are the compensation and audit committees composed entirely of outsiders?

Disney was the only S&P 500 company to fail all three tests.

Christo Pirinsky
2-15
The Disney Experience - 1997
Christo Pirinsky
2-16
Business Week piles on The Worst Boards in 1997..
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2-17
Compensation Packages: Walt Disney Co.
1997 $10.7
1998 $575.6
1999 $50.7
2000 $72.8
2001 $1.0
2002 $6.1
2003 $7.3
2004 $8.3
Michael Eisners (CEO) Compensation ($M):
Source: ExecuComp, 2005
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
Q
1

1
9
8
4
Q
3

1
9
8
5
Q
1

1
9
8
7
Q
3

1
9
8
8
Q
1

1
9
9
0
Q
3

1
9
9
1
Q
1

1
9
9
3
Q
3

1
9
9
4
Q
1

1
9
9
6
Q
3

1
9
9
7
Q
1

1
9
9
9
Q
3

2
0
0
0
Q
1

2
0
0
2
Q
3

2
0
0
3
Q
1

2
0
0
5
DPS EPS
Walt Disney Co. Performance:
Christo Pirinsky
2-18
Effective Boards of Directors
Large number of independent member.
Is not an interlocking board (CEO of company A sits on board of company
B, CEO of B sits on board of A).
Board members are not unduly busy (i.e., sit on too many other boards or
have too many other business activities)
Compensation for board directors is appropriate
Not so high that it encourages cronyism with CEO
Not all compensation is fixed salary (i.e., some compensation is linked to firm
performance or stock performance)


Christo Pirinsky
2-19
In response, boards are becoming more independent
Large Boards have become smaller over time. The median size of a board of directors
has decreased from 16 to 20 in the 1970s to between 9 and 11 in 1998. The smaller
boards are less unwieldy and more effective than the larger boards.
There are fewer insiders on the board. In contrast to the 6 or more insiders that many
boards had in the 1970s, only two directors in most boards in 1998 were insiders.
Directors are increasingly compensated with stock and options in the company,
instead of cash. In 1973, only 4% of directors received compensation in the form of
stock or options, whereas 78% did so in 1998.
More directors are identified and selected by a nominating committee rather than
being chosen by the CEO of the firm. In 1998, 75% of boards had nominating
committees; the comparable statistic in 1973 was 2%.

Christo Pirinsky
2-20
Changes in corporate governance at Disney
Required at least two executive sessions of the board, without the CEO or other
members of management present, each year.
Created the position of non-management presiding director, and appointed Senator
George Mitchell to lead those executive sessions and assist in setting the work agenda
of the board.
Adopted a new and more rigorous definition of director independence.
Required that a substantial majority of the board be comprised of directors meeting
the new independence standards.
Provided for a reduction in committee size and the rotation of committee and
chairmanship assignments among independent directors.
Added new provisions for management succession planning and evaluations of both
management and board performance
Provided for enhanced continuing education and training for board members.
Christo Pirinsky
2-21
Disneys board in 2008
Christo Pirinsky
2-22
Valuation Project I
Look at the board of directors for your firm. Analyze
How many of the directors are inside directors (Employees of the firm, ex-
managers)?
Is there any information on how independent the directors in the firm are from the
managers?

Are there any external measures of the quality of corporate governance of your
firm?
Yahoo! Finance now reports on a corporate governance score for firms, where it
ranks firms against the rest of the market and against their sectors.
Christo Pirinsky
2-23
How Could Managers Misbehave?
Over-investment (avoid returning capital to investors)
Power
Entrenchment
Loyalty to friends in company
Short-term gain
Under-investment
Low effort
Loyalty to friends in company
High compensation
Salary
Non-pecuniary benefits

Christo Pirinsky
2-24
Overpaying on takeovers
The quickest and perhaps the most decisive way to impoverish stockholders is
to
Make bad acquisitions
Overpay in takeovers
The stockholders in acquiring firms do not seem to share the enthusiasm of the
managers in these firms.
Stock prices of bidding firms decline on the takeover announcements a significant
proportion of the time.
The profitability of merged firms relative to their peer groups, does not increase
significantly after mergers.
A large number of mergers are reversed within a few years, which is a clear
admission that the acquisitions did not work.
Christo Pirinsky
2-25
Symantec buys Veritas for $10.5 billion in 2005
When security company Symantec announced plans to buy data back-up and
storage Veritas in December 2004, the deal was valued at $13.5 billion.
Investors hated the deal so much, they bid Symantec's price down so the final
deal was actually worth only $10.5 billion when it closed in summer 2005.


Christo Pirinsky
2-26
Why do managers over-invest?
They could extract private benefits from investment
Entrenchment
Connections
Promotions
Ego and prestige
They could be overconfident (hubris hypothesis)
Warren Buffet, once said that many corporate acquirers think of themselves as
beautiful princesses, sure that their kisses can turn toads into handsome princes.
The acquirers pay substantial premiums over market value, believing that they can
release the imprisoned princes. But, as Buffet said, Weve observed many kisses
but very few miracles.
Note that it is also possible that managers under-invest, especially when they
are insulated from takeovers (enjoying the quiet life)
Christo Pirinsky
2-27
Valuation Project I
Look at the capital expenditures of your firm.
Did the firm make any takeover bids?
Did it acquire other firms?

Was the firm subject to takeover attempts?
Who was the bidder?
Why didnt the deal go through?
Christo Pirinsky
2-28
The Growth (and failure) of Executive Compensation
According to a Business Week article (5/6/2002), the average chief executive
officers pay increased from 42 times that of the average production workers
pay to 411 times in 2001.

A number of studies have found that there is no correlation between executive
compensation and firm performance.

Recent work by Erickson, Hanlon, and Maydew (2003) found that executive
compensation plans weighted more heavily toward stock compensation were
related to the incidence of accounting fraud.

The amount of perks and non-pecuniary benefits have been also increasing
over time.
Christo Pirinsky
2-29
CEO Perquisites: Personal Jet Use
Use of personal jet by CEOs in 237 Forbes 500 Companies

Source: Yermack (2005, Journal of Financial Economics)
Eighty Percent of
Success is Showing Up

Woody Allen
Christo Pirinsky
2-30
The Growth (and failure) of Executive Compensation
There is evidence that
Top managers have too much influence on setting their own pay
Boards have not done a good job of connecting executive compensation to
performance (however performance is defined)

Bills like the Sarbanes-Oxley Act of 2003 represent attempts to deal with
inherent agency problems and conflicts of interest (on the latter, issues like
auditor independence). Boards and senior managers are much more
accountable for the accuracy of their financial reporting than before.

Is high compensation only managerial excess?
Managerial job market is highly competitive
And there is free entry into the market (workers have the option to become
managers)
Christo Pirinsky
2-31
Corporate Governance
The set of laws, rules, and procedures that influence a companys operations
and the decisions made by its managers.

Mechanisms
Internal
External

Methods
Sticks (threat of removal)
Carrots (compensation)
Christo Pirinsky
2-32
Corporate Governance Mechanisms
Internal Governance





External Governance


Christo Pirinsky
2-33
Corporate Governance Mechanisms
Internal Governance
Insider ownership
Capital structure - leverage
Managerial compensation
Board of directors
Ownership structure

External Governance
Market for Corporate Control
Shareholder activism
Christo Pirinsky
2-34
Ownership structure
In 1989 Michael Jensen (HBS) announced that the publicly held corporation,
the main engine of economic progress in the United States for a century, has
outlived its usefulness in many sectors of the economy and is being eclipsed."

The problem with the Public Corporation: passive investors
Individual investors. Most individual investors own small stakes and their
holdings are very diffuse. They have little to no influence in the operations of
corporations. The free rider problem. The presence of individuals is declining. They
sold 38% of their holdings between 1984 and 1989 - half a trillion dollars.
Institutional investors. Pension plans, insurance companies, banks, and mutual
funds control about 70% of corporate equity. They are responsible for about 95% of
trading volume on the stock exchanges. Institutions have typically played a very
passive role in the way corporations are run.

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2-35
Outside Monitoring
Certain investors are better at monitoring.
They could extract private benefits from monitoring
Effectively provide a public good

Who are these investors?
Individual block-holders: Accumulate voting power.
Founders and Family-owners: They are emotionally attached to the business.
Most of the restructuring in Walt Disney Co. in 2004-2005 was carried out by
member of the Disney family.
Institutional investors: Some are active: send formal letter to company, sometimes
publicized, informing selection and requesting dialogue. Could form coalitions,
accumulate voting power, and change corporate management (e.g., Calpers, the
Lens Funds)

Christo Pirinsky
2-36
Valuation Project I
Who owns/runs your firm? (Sources: Yahoo! Finance, Bloomberg)
Who are the top stockholders in your firm?
What are the potential conflicts of interests that you see emerging from this
stockholding structure?

Investor classes and impact on governance
Founders / family
Insider ownership
Employee ownership
Board ownership
Institutional investors: active or passive / short-term or long-term

Christo Pirinsky
2-37
The Hostile Acquisition Threat
The typical target firm in a hostile takeover has
a return on equity almost 5% lower than its peer group
had a stock that has significantly under performed the peer group over the previous
2 years
has managers who hold little or no stock in the firm

In other words, the best defense against a hostile takeover is to run your firm
well and earn good returns for your stockholders

Conversely, when you do not allow hostile takeovers, you provide
entrenchment for the management
Christo Pirinsky
2-38

Agency Cost of Minority-shareholders: Tunneling
In US, most shares have one vote. Yet majority shareholders could be the
decision-making authority in the firm.

It is possible to have two types of shares
Voting: Provide cash-flow rights and control rights
Non-voting: Provide only cash-flow rights

Aracruz Cellulose, like most Brazilian companies, has multiple classes of
shares.
The common shares have all of the voting rights and are held by incumbent
management, lenders to the company and the Brazilian government.
Outside investors hold the non-voting shares, which are called preferred shares,
and have no say in the election of the board of directors.

How can majority owners expropriate wealth from minority owners?
Christo Pirinsky
2-39
Tunneling
Cash flow tunneling
Excessive salary
Perk consumption, a $6,000 shower curtain
Transfer pricing

Asset tunneling
Asset stripping: sell productive assets to
related party
Buy overpriced assets from related party

Equity tunneling
Dilution: selling new offerings
Freeze out: forcing minority shareholders out (terminating dividends)
Excessive equity compensation
Insider trading

Christo Pirinsky
2-40
The Three Types of Tunneling
Imagine an apple-tree orchard, jointly owned by two investors C (controlling)
and M (minority)

Cash flow tunneling
C steals some apples
Asset Tunneling
C cuts some trees and uses them for building
material for himself or simply sells the
material to a third party

Equity Tunnelingq
C convinces M to transfer his ownership to C
at a relatively low price

Christo Pirinsky
2-41
Example: Tunneling
Firm ADL has 100 shares outstanding 50 of which are owned by a majority shareholder
(the other 50 shares are diffusely owned). The next year FCF to the firm will be 10 and it
is expected to grow at the rate of 2% per year. The cost of capital is 12%.

What is the value of the firm and the value of the majority stake?
V = 10 / (0.12 0.02) = 10 / 0.1 = 100
Vm = V*0.5 = 50

The controlling shareholder is considering an action that will reduce the next year FCF to
the firm by 2 and will generate immediate private benefit in the amount of 12. What is the
value of the firm and the value of the majority stake in this case (including the value of the
private benefit)? The cost of capital and the growth rate stay the same.
V =
Vm =
Christo Pirinsky
2-42
Example: Tunneling
Firm ADL has 100 shares outstanding 50 of which are owned by a majority shareholder
(the other 50 shares are diffusely owned). The next year FCF to the firm will be 10 and it
is expected to grow at the rate of 2% per year. The cost of capital is 12%.

What is the value of the firm and the value of the majority stake?
V = 10 / (0.12 0.02) = 10 / 0.1 = 100
Vm = V*0.5 = 50

The controlling shareholder is considering an action that will reduce the next year FCF to
the firm by 2 and will generate immediate private benefit in the amount of 12. What is the
value of the firm and the value of the majority stake in this case (including the value of the
private benefit)? The cost of capital and the growth rate stay the same.
V = 8 / (0.12 0.02) = 8 / 0.1 = 80
Vm = V*0.5 + PB = 40 + 12 = 52 > 50
Christo Pirinsky
2-43
Example: Tunneling
Without tunneling
V = 10 / (0.12 0.02) = 10 / 0.1 = 100
Vm = V*0.5 = 50

With tunneling
V = 8 / (0.12 0.02) = 8 / 0.1 = 80
Vm = V*0.5 + PB = 40 + 12 = 52 > 50

Will the majority shareholder undertake the tunneling action (cut some of the trees)?
What is the net benefit to the majority shareholder? What is the total loss to society?
Value added to majority shareholder =
Drop in firm value =
Total loss to society including the private benefit =

Christo Pirinsky
2-44
Example: Tunneling
Without tunneling
V = 10 / (0.12 0.02) = 10 / 0.1 = 100
Vm = V*0.5 = 50

With tunneling
V = 8 / (0.12 0.02) = 8 / 0.1 = 80
Vm = V*0.5 + PB = 40 + 12 = 52 > 50

Will the majority shareholder undertake the tunneling action (cut some of the trees)?
What is the net benefit to the majority shareholder? What is the total loss to society?
Value added to majority shareholder = 52 50 = 2
Drop in firm value = 100 80 = 20
Total loss to society including the private benefit = 20 12 = 8

Christo Pirinsky
2-45
Horizontal Agency Problems
Christo Pirinsky
2-46
Stockholders objectives vs. Bondholders objectives
Stockholder and bondholders have different objectives. Bondholders are
concerned most about safety and ensuring that they get paid their claims.
Stockholders are more likely to think about upside potential.
The problem is that equity holders make the decisions.
Debt-holders know that: covenants, no long-term (non-callable) debt

Examples of the conflict
Increasing dividends significantly: lenders to the firm are hurt and stockholders
may be helped. This is because the firm becomes riskier without the cash.
Taking riskier projects than those agreed to at the outset: Lenders base interest rates
on their perceptions of how risky a firms investments are. If stockholders then take
on riskier investments, lenders will be hurt.
Borrowing more on the same assets: If lenders do not protect themselves, a firm
can borrow more money and make all existing lenders worse off.

Christo Pirinsky
2-47
An Extreme Example: Unprotected Lenders?
Christo Pirinsky
2-48
The Bondholders Defense Against Stockholder Excesses
More restrictive covenants on investment, financing and dividend policy have been
incorporated into both private lending agreements and into bond issues, to prevent
future Nabiscos
New types of bonds have been created to explicitly protect bondholders against sudden
increases in leverage or other actions that increase lender risk substantially. Two
examples of such bonds
Puttable Bonds, where the bondholder can put the bond back to the firm and get face value, if
the firm takes actions that hurt bondholders
Ratings Sensitive Notes, where the interest rate on the notes adjusts to that appropriate for the
rating of the firm
More hybrid bonds (with an equity component, usually in the form of a conversion
option or warrant) have been used. This allows bondholders to become equity investors,
if they feel it is in their best interests to do so.
Christo Pirinsky
2-49
Stockholders vs. others stakeholders
Employees
Implicit contracts and firm-specific investment
Breach of implicit contracts (e.g., takeovers)

Government
Tax loopholes

Society
Environmental costs (pollution, health costs, etc..)
Quality of Life' costs (traffic, housing, safety, etc.)
Christo Pirinsky
2-50
A test on social consciousness
Assume that you work for Disney and that you have an opportunity to open a store
in an inner-city neighborhood. The store is expected to lose about a million dollars
a year, but it will create much-needed employment in the area, and may help
revitalize it.

Would you open the store?
a) Yes
b) No
If yes, would you tell your stockholders and let them vote on the issue?
a) Yes
b) No
If no, how would you respond to a stockholder query on why you were not
living up to your social responsibilities?
Christo Pirinsky
2-51
An Alternative Corporate Governance System
Germany and Japan developed a different mechanism for corporate
governance, based upon corporate cross holdings.
In Germany, the banks form the core of this system
In Japan, it is the Keiretsu
Other Asian countries have modeled their system after Japan, with family
companies forming the core of the new corporate families

At their best, the most efficient firms in the group work at bringing the less
efficient firms up to par. They provide a corporate welfare system that makes
for a more stable corporate structure
At their worst, the least efficient and poorly run firms in the group pull down
the most efficient and best run firms down. The nature of the cross holdings
makes its very difficult for outsiders (including investors in these firms) to
figure out how well or badly the group is doing.
Christo Pirinsky
2-52
Managers control the release of information to the public
Information (especially negative) is sometimes suppressed by managers
seeking a better time to release it. What time is better?
Later: when other people are in charge!?
In bad economy. Why?

More bad news are released on
Fridays relative to other weekdays: failed producs, a recall, a Securities and
Exchange Commission investigation
Burying the bad news
Christo Pirinsky
2-53
Is there a payoff to better corporate governance?
In the most comprehensive study of the effect of corporate governance on value, a
governance index was created for each of 1500 firms based upon 24 distinct corporate
governance provisions.
Buying stocks that had the strongest investor protections while simultaneously selling shares
with the weakest protections generated an annual excess return of 8.5%.
Every one point increase in the index towards fewer investor protections decreased market
value by 8.9% in 1999
Firms that scored high in investor protections also had higher profits, higher sales growth and
made fewer acquisitions.
The link between the composition of the board of directors and firm value is weak.
Smaller boards do tend to be more effective.
On a purely anecdotal basis, a common theme at problem companies is an ineffective
board that fails to ask tough questions of an imperial CEO.