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
Prof. Marco Bigelli - DSA - Università di 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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Prof. Marco Bigelli - DSA - Università di Bologna
Corporate governance models
United States
Great Britain
Germany
Japan
Continental European countries
Mktoriented(arm’s length
based)
Bank
Oriented(relationship-
based)
Prof. Marco Bigelli - DSA - Università di Bologna
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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Prof. Marco Bigelli - DSA - Università di Bologna
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
Prof. Marco Bigelli - DSA - Università di Bologna
…Germany
Universal Bank(Shares + proxies)
Diapositiva 5
M1 Marco; 26/02/2007
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Prof. Marco Bigelli - DSA - Università di Bologna
Japan
KeiretsuFinancial Institutions are the most
important blockholder (Prowse JF ’92)Internal capital marketsLong term relationshipsNo mkt myopia (high R&D)
Prof. Marco Bigelli - DSA - Università di Bologna
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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Prof. Marco Bigelli - DSA - Università di Bologna
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
Prof. Marco Bigelli - DSA - Università di Bologna
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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Prof. Marco Bigelli - DSA - Università di Bologna
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)
Prof. Marco Bigelli - DSA - Università di Bologna
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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Prof. Marco Bigelli - DSA - Università di Bologna
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
Prof. Marco Bigelli - DSA - Università di Bologna
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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Prof. Marco Bigelli - DSA - Università di Bologna
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
Prof. Marco Bigelli - DSA - Università di Bologna
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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Prof. Marco Bigelli - DSA - Università di Bologna
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
Prof. Marco Bigelli - DSA - Università di Bologna
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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Prof. Marco Bigelli - DSA - Università di Bologna
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)
Prof. Marco Bigelli - DSA - Università di Bologna
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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Prof. Marco Bigelli - DSA - Università di Bologna
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
Prof. Marco Bigelli - DSA - Università di Bologna
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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Prof. Marco Bigelli - DSA - Università di Bologna
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
Prof. Marco Bigelli - DSA - Università di Bologna
Incentive schemes
Source: B.J.Hall and K.J. Murphy 2000
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Prof. Marco Bigelli - DSA - Università di Bologna
Incentive schemes
Prof. Marco Bigelli - DSA - Università di Bologna
Stock options
Strike priceMostly at the money
Vesting periodMore firm’s lojalty
Save costs and cashBetter economic margins and eps
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Prof. Marco Bigelli - DSA - Università di Bologna
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
Prof. Marco Bigelli - DSA - Università di Bologna
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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Prof. Marco Bigelli - DSA - Università di Bologna
Stock options and fraudolent behaviour
Prof. Marco Bigelli - DSA - Università di Bologna
Enron and insiders’ sales before the crash
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Prof. Marco Bigelli - DSA - Università di Bologna
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
Prof. Marco Bigelli - DSA - Università di Bologna
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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Prof. Marco Bigelli - DSA - Università di Bologna
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!
Prof. Marco Bigelli - DSA - Università di Bologna
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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Prof. Marco Bigelli - DSA - Università di Bologna
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.)
Prof. Marco Bigelli - DSA - Università di Bologna
Hermes UK Focus Fund Investment Process
Becht, Mayer, Franks and Rossi, ECGI WP 136/2006
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Prof. Marco Bigelli - DSA - Università di Bologna
Hermes UK Focus Fund Engagement Process
Becht, Mayer, Franks and Rossi, ECGI WP 136/2006
Prof. Marco Bigelli - DSA - Università di Bologna
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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Prof. Marco Bigelli - DSA - Università di Bologna
•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?
Prof. Marco Bigelli - DSA - Università di Bologna
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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Prof. Marco Bigelli - DSA - Università di Bologna
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.
Prof. Marco Bigelli - DSA - Università di Bologna
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.
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