1-2 corporate governance, public companies and agency costs

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Prof. Marco Bigelli - University of Bologna

Corporate governanceCorporate governanceAgencyAgency--Costs from separation of ownership and control: Costs from separation of ownership and control:

internal and external solutionsinternal and external solutions

Marco Bigelli

Department of ManagementUniversity 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

2


Corporate governance models

� United States

� Great Britain

�Germany

�Japan

�Continental European countries

Mkt oriented(arm’s length

based)

Bank

Oriented(relationship-

based)


Corporate governance models

Typical form of control Shareholders

US, UK Public company Small shareholdersInstitutionalinvestors

Germany Large shareholder Banks (big comp.), Family (small comp.)

Japan KeiretsuCross-ownership

Banks

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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

M1


…Germany

Universal Bank (Shares + proxies)

Diapositiva 5

M1 Marco, 26/02/2007

4


Japan

�Keiretsu: network of companies with a main bank


Japan

Advantages:Advantages:

- internal capital market

- soft solutions for financial distress

Disadvantages:Disadvantages:

-No mkt for corporate control

-Banks risk to go broken

�Financial Institutions are the most important block-holder (Prowse JF ’92)�Internal capital markets�Long term relationships and no mkt myopia (high R&D)

5


US and UK

�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

Public company


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 interestsDisallignement of interests

Agency costs

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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

alignment 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 alignment of interests between shareholders and managers

Hence, JM expects a linear relationship between managerial ownerhip (alfa) and firm’s performance (measured by Tobin’s Q)

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Internal and external solutions for reducing agency costs from O/C separation

�� 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

Solutions

Internal

Solutions


Market for products andMarket for products and

Market for managersMarket for managers

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� Inefficient companies will progressively have a Inefficient companies will progressively have a lower market share and will eventually be out of the lower market share and will eventually be out of the market market (Hart,83)� Even when it works, its action comes too late, when all wealth has been destroyed and efficiency can’t 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 products


��Mkt for managersMkt 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

• No easy to remove high managers

• The higher the position the older the age (reputation effect less important)

•Board not enough active

Mkt for managers

Actually, this force is not too effective as:

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Market for Corporate ControlMarket for Corporate Control


Mkt for corporate control

� Manne ( JPE ‘65), Jensen Ruback (JFE ‘83)� public company� efficient mrkets

Agency costs => Price down

M&A 80sM&A 80s (Jensen, 93):$ 2.6 trillion

Avg premium paid: 41%750 billion $ value creation

MSV(89): Low performance

(active board . or M&A)

poison pills, antitakeover laws

Case: RJR Nabisco

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Entrenchment theory

� The threat of a takeover may induce managers to be The threat of a takeover may induce managers to be more efficient not to risk to be taken over and more efficient not to risk to be taken over and removedremoved��For higher values of managerial ownership For higher values of managerial ownership managers become more entrenched and difficult to be managers become more entrenched and difficult to be removed (for alfa > 25%, hostile takeovers were never removed (for alfa > 25%, hostile takeovers were never successful). The relationship between firm’s efficiency successful). The relationship between firm’s efficiency and managerial ownership may not be monotonic and managerial ownership may not be monotonic (Fama Jensen 1983) since:(Fama Jensen 1983) since:��Agency costs depend on two forces:Agency costs depend on two forces:

�Alignment of interests�Managerial entrenchment


0 0.2 0.4 0.6 0.8 1

alfa

Q

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

Empirical evidence on firm’s performance and managerial ownership

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

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The board of directorsThe 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 (JPE’90),

�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

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Stated reasons for CEOs’ Turnover


Examples of CEO Succession cases

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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)

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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

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The disciplining role of debtThe disciplining role of debt

(and its abuses)(and its abuses)


FCF hypothesis (Jensen, AER86)

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

LBOs

Value creation through minimization of agency costs through debt and more

optimal contracts

DEBT and Free Cash Flows

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LBOs and Private Equity Funds


The Private Equity Bubble

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The Private Equity Bubble


Much more leverage than before

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Low credit spreads help high leverages


Higher leverage allow higher prices in acquisitions

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Incentive scheme and stock optionsIncentive scheme and stock options

(and its abuses)(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 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”)

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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


Incentive schemes

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

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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

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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”

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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

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Stock options and fraudolent behaviour


Enron and insiders’ sales before the crash

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The perfect payday for Eads’ Ceo

Delay announced in Delay announced in the A380 superjumbo the A380 superjumbo

programmeprogramme

Noël Forgeard (coNoël Forgeard (co--CEO):CEO):2.5 million 2.5 million €€ profit on profit on

the options exercise and the options exercise and sell offsell off

32,0132,01

Ex.price: 15,65Ex.price: 15,65--16,9616,96


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

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Fuld’s compensation structure

Salary & other

compensationCash bonus

Option

exerciceStock sales Total

2000 763,710 8,800,000 43,000,000 - 52,563,710

2001 762,517 4,000,000 93,600,000 - 98,362,517

2002 763,008 1,100,000 21,100,000 - 22,963,008

2003 764,439 6,700,000 37,500,000 - 44,964,439

2004 766,028 10,300,000 13,900,000 - 24,966,028

2005 767,791 13,800,000 75,000,000 - 89,567,791

2006 939,585 6,800,000 31,900,000 67,100,000 106,739,585

2007 903,169 4,300,000 40,300,000 - 45,503,169

Total 6,430,247 55,800,000 356,300,000 67,100,000 485,630,247

Performance based compensation of Richard Fuld [2000-2008]


Lehman’s case: performance-based compensation

Compensation design is 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

Compensation design is not linked to risky decisions

• Fuld suffered large losses when Lehman collapsed

• His risk-taking decisions were due to his failure to perceive risks…

• … and overall an extra-large ego, in fact, until September 15 he refused to acknowledge Lehman was in trouble

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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

28


Major novelties from the Dodd-Frank Act (July 2010)

Vote on Executive Pay and Golden Parachutes: Givesshareholders a say on pay with the right to a non-bindingvote on executive pay and golden parachutes. This givesshareholders a chance to disapprove where they see thekind of misguided incentive schemes.

No Compensation for Lies: Requires that public companiesset policies to take back executive compensation if it wasbased on inaccurate financial statements that don’tcomply with accounting standards.

SEC Review: Directs the SEC to clarify disclosures relatingto compensation, including requiring companies to providecharts that compare their executive compensation withstock performance over a five-year period.


Major novelties from the Dodd-Frank Act (July 2010)

Independent Compensation Committees: Standards forlisting on an exchange will require that compensationcommittees include only independent directors and haveauthority to hire compensation consultants in order tostrengthen their independence from the executives theyare rewarding or punishing.

Enhanced Compensation Oversight for Financial Industry:Requires Federal financial regulators to issue and enforcejoint compensation rules specifically applicable tofinancial institutions with a Federal regulator.

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BackdatingBackdatingBackdating allows executives to choose a past date Backdating allows executives to choose a past date when the market price was particularly low, thereby when the market price was particularly low, thereby

inflating the value of the options.inflating the value of the options.


BackdatingBackdating

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BackdatingBackdating

Around 29 % of options were backdated from 1992 to 2002

80 investigations led by SEC in 2006

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

POSSIBLE SOLUTIONS:


Analysts’ advises …

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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 investorsMonitoring and active investors

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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.)

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Hermes UK Focus Fund Investment Process

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


Hermes UK Focus Fund Engagement Process

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

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Activist in Italian listed companies at April 15th 2009

Source: Erede 2009


Some references

�Alchian A. A. e H. Demsetz (1972), “Production, Information C osts, andEconomic 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 eproprietà privata , Einaudi, Torino, 1966.�Diamond D. W. (1984), “Financial Intermediation and Delegat ed Monitoring”in Review of Economic Studies , pp. 393-414.�Fama E. (1980), “Agency Problems and the Theory of the Firm” i n Journal ofPolitical Economy , vol. 88, n.2, pp. 288-307.�Fama E. e M. C. Jensen (1983), “Separation of Ownership and Con trol” inJournal of Law and Economics , vol. 26, giugno, pp. 301-325.�Grossman S. J. e O. D. Hart (1980), “Takeover Bids, the Free-Ri der Problemand 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: Manageri al 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, Corpor ate Financeand Takeovers” in American Economic Review , settembre-ottobre, pp. 305-360.�Jensen M. C. e K. J. Murphy (1990a), “CEO Incentives - It’s Not H ow MuchYou 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 Top-Management Incentives” in Journal of Political Economy , n. 98, pp. 225-264.�Leland H. E. e D. H. Pyle (1977), "Informational Asymmetries , FinancialStructure, and Financial Intermediation" in Journal of Finance, vol. 32, n. 2,pp. 370-387.�Manne H. G. (1965), “Mergers and the Market for Corporate Cont rol” inJournal of Political Economy , vol. 73, n. 4, pp. 110-120.�Morck R., A. Shleifer e R. W. Vishny (1988), “Management Owner ship andMarket 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 Pub licBoard s” in Harvard Business Review , maggio-giugno, pp. 28-35.�Shleifer A. e Vishny R. W. (1986), “Large Shareholders and Cor porateControl” 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 Director s and CEO Turnover” in Journal ofFinancial Economics , vol. 20, pp. 431-460.

1-2 corporate governance, public companies and agency costs

Documents

marco bigelli university

bolognaagency costs

separation of ownership

controlagency costs

agency costs of debt

equityagency costs of

corporate controlbanks

mkt price