1 2 Corporate Governance, Public Companies And Agency Costs

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1 2 Corporate Governance, Public Companies And Agency Costs

  1. 1. 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 Prof. Marco Bigelli - DSA - Università di Bologna 1
  2. 2. Corporate governance models United States Mkt Great Britain oriented (arm’s length based) Germany Bank Japan Oriented Continental European countries (relationship- based) Prof. Marco Bigelli - DSA - Università di Bologna Corporate governance models 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 Prof. Marco Bigelli - DSA - Università di Bologna 2
  3. 3. 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 Prof. Marco Bigelli - DSA - Università di Bologna …Germany Universal Bank (Shares + proxies) Prof. Marco Bigelli - DSA - Università di Bologna 3
  4. 4. Diapositiva 5 M1 Marco; 26/02/2007
  5. 5. Japan Keiretsu Financial Institutions are the most important blockholder (Prowse JF ’92) Internal capital markets Long term relationships No 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: Disadvantages: - internal capital market -No mkt for corporate control - soft solutions for financial -Banks risk to go broken distress Prof. Marco Bigelli - DSA - Università di Bologna 4
  6. 6. 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 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 Prof. Marco Bigelli - DSA - Università di Bologna 5
  7. 7. 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) Prof. Marco Bigelli - DSA - Università di Bologna 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 Prof. Marco Bigelli - DSA - Università di Bologna 6
  8. 8. 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 Prof. Marco Bigelli - DSA - Università di Bologna 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 Prof. Marco Bigelli - DSA - Università di Bologna 7
  9. 9. 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 Prof. Marco Bigelli - DSA - Università di Bologna 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? Prof. Marco Bigelli - DSA - Università di Bologna 8
  10. 10. 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 Prof. Marco Bigelli - DSA - Università di Bologna 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) Prof. Marco Bigelli - DSA - Università di Bologna 9
  11. 11. 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) 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: 1999 Finland and Germany: 2000 Denmark 2001 Austria: 2002 Prof. Marco Bigelli - DSA - Università di Bologna 10
  12. 12. 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 Prof. Marco Bigelli - DSA - Università di Bologna 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”) Prof. Marco Bigelli - DSA - Università di Bologna 11
  13. 13. 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 Prof. Marco Bigelli - DSA - Università di Bologna Incentive schemes Source: B.J.Hall and K.J. Murphy 2000 Prof. Marco Bigelli - DSA - Università di Bologna 12
  14. 14. Incentive schemes Prof. Marco Bigelli - DSA - Università di Bologna Stock options Strike price Mostly at the money Vesting period More firm’s lojalty Save costs and cash Better economic margins and eps Prof. Marco Bigelli - DSA - Università di Bologna 13
  15. 15. 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 Prof. Marco Bigelli - DSA - Università di Bologna 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” Prof. Marco Bigelli - DSA - Università di Bologna 14
  16. 16. Stock options and fraudolent behaviour Prof. Marco Bigelli - DSA - Università di Bologna Enron and insiders’ sales before the crash Prof. Marco Bigelli - DSA - Università di Bologna 15
  17. 17. 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 Prof. Marco Bigelli - DSA - Università di Bologna Backdating Backdating allows executives to choose a past date when the market price was particularly low, thereby inflating the value of the options. Prof. Marco Bigelli - DSA - Università di Bologna 16
  18. 18. 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 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) Prof. Marco Bigelli - DSA - Università di Bologna 17
  19. 19. 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.) Prof. Marco Bigelli - DSA - Università di Bologna Hermes UK Focus Fund Investment Process Becht, Mayer, Franks and Rossi, ECGI WP 136/2006 Prof. Marco Bigelli - DSA - Università di Bologna 18
  20. 20. 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 Prof. Marco Bigelli - DSA - Università di Bologna 19
  21. 21. 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 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 Prof. Marco Bigelli - DSA - Università di Bologna 20
  22. 22. 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), 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. Prof. Marco Bigelli - DSA - Università di Bologna 21

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