boards of directors and capital structure

8/11/2019 Boards of Directors and Capital Structure

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Journal of

CORPORATE

FINANCE

E LSEVIE R Journal of Corporate Finance 3 (1997) 113 139

B o a r d s o f d i r e c t o r s a n d c a p i t a l s t r u c t u r e :

A l t e r n a t i v e f o r m s o f c o r p o r a t e r e s t r u c t u r i n g

E r n st M a u g *

F u q u a S c h o o l o f B u s i n e s s , D u k e U n i t, e r si ty , P . O . B o x 9 0 1 2 0 , D u r h a m , N C 2 7 7 0 8 , U S A

A b s t r a c t

This paper discusses a model that combines internal and external control mechanisms in

a firm in which assets can have alternative uses that are in some states more profitable than

the current one. However, restructuring a firm in order to realize the gains from alternative

uses affects managers adversely since they invest in firm-speci fic human capital. Managers

can be motivated to restructure the firm through their compensation scheme. Alternatively,

investors can acquire costly information on the firm and interfere with managers' decisions.

The main focus is on independent directors, who review and monitor contracts and

managers' compensation. If information is not too costly, directors are the optimal

institution to check managerial discretion and the degree of managerial entrenchment

depends on the compensation of independent directors. However, if directors fail to exercise

control over management properly, takeovers or creditor control become second-best

solutions. If information is costly to transfer, unchecked managerial control may be optimal.

JEL classif ication." G32; G33:G34

Keywo rd s . "

Capital structure; Corporate restructuring; Internal control mechanisms; Boards of directors

: Takeovers; Agency theory

* Tel.: ( +1) 919-660.7753; fax: (+1) 919-660.8038; e-mail: [email protected]; web:

http://www.duke.edu/~ maug.

0929-1199/97/$17.00 Copyright 1997 Elsevier Science B.V. All rights reserved.

P I I

S0929-1199(96)00010-7


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1 1 4

E. Maug /J ournal q[Corporate Finance 3 (1997) 113 139

T h e t r ad e o f a j o i n t s t o ck c o m p a n y i s a l w a y s m a n a g e d b y a c o u r t o f

d i r e c t o r s . T h i s c o u r t , i n d e e d , i s f r e q u e n t l y s u b j e c t (. . .) to t h e c o n t r o l o f a

g e n e r a l c o u r t o f p r o p r ie t o r s . B u t t h e g r e a t e r p a r t o f th e s e p r o p r i e t o r s s e l d o m

p r e t e n d t o u n d e r s t a n d a n y t h i n g o f t h e b u s i n e s s o f t h e c o m p a n y ; a n d w h e n

t h e s p i ri t o f f a c t i o n s h a p p e n s n o t t o p r e v a i l a m o n g t h e m , g i v e t h e m s e l v e s n o

t r o u b l e a b o u t i t, b u t r e c e i v e c o n t e n t e d l y s u c h h a l f y e a r l y o r y e a r l y d i v i d e n d ,

a s t h e d i r e c t o r s t h i n k p r o p e r t o m a k e t o t h e m . A d a m S m i t h (1 9 2 5 , p . 2 6 2 )

1 . I n t r o d u c t i o n

H o w c a n m a n a g e r s i n a l a r g e c o r p o r a t i o n b e h e l d a c c o u n t a b l e , s o t h a t t h e y a r e

r e s p o n s i v e t o t h e i n t e r e s ts o f s h a r e h o l d e r s a n d s t il l h a v e s u f f i c ie n t d i s c r e t i o n o v e r

b u s i n e s s d e c i s i o n s ? T h i s p a p e r i n v e s t i g a t e s t h e r o l e o f i n d e p e n d e n t d i r e c t o r s l o m

a n o p t i m a l c o n t r a c t i n g p e r s p e c t i v e , a n d t r ie s to s h o w h o w t h is i n s t i tu t i o n c a n b e

u n d e r s t o o d a s a n a n s w e r t o th i s q u e s t i o n . T h e a i m i s t o c o n t r a s t i n d e p e n d e n t o r

o u t s i d e d i r e c t o r s w i t h a l t e r n a t i v e m e c h a n i s m s t h a t r e g u l a t e t h e a g e n c y r e l a t i o n s h i p

b e t w e e n e x e c u t i v e m a n a g e m e n t a n d s h a r e h o l d e rs , s u c h a s th e m a r k e t f o r c o r p o r a t e

c o n t r o l , o r t h e c o n t r o l e x e r c i s e d b y c r e d i t o r s t h r o u g h d e b t c o n t r a c t s .

A d a m S m i t h ( 1 9 2 5) b e l i e v e d th a t t h e a g e n c y p r o b l e m b e t w e e n o w n e r s a n d

m a n a g e r s p o s e d s u c h a n o b s t a c l e a s t o m a k e i t q u e s t i o n a b l e w h e t h e r th e m o d e m

c o r p o r a t i o n w i t h i t s s e p a r a t i o n o f o w n e r s h i p a n d c o n t r o l is a v i a b l e i n s ti t u ti o n .

H o w e v e r , t h e s e p a r a t io n o f o w n e r s h i p a n d c o n t r o l h a s p r o v e d t o b e v i a b l e, t h e re b y

i n d i c a t i n g th a t th e i m p l i e d a g e n c y p r o b l e m c a n b e r e g u l a t e d e f f e c t i v e l y .

T h e m o d e l d i s c u s s e d b e l o w f o c u s e s o n a c o r p o r a t e re s t ru c t u r in g p r o b l e m in

o r d e r t o c o m p a r e a l t e r n a t i v e g o v e r n a n c e s t r u c t u r e s. T h e a s s e t s o f t h e f ir m h a v e

a l t e r n a t i v e u s e s t o t h e c u r r e n t o n e , a n d i n s o m e s t a t e s i t i s o p t i m a l t o r e a l l o c a t e t h e

a s s e t s ( e . g . a d i v e s t i t u r e ) . I n t h i s c a s e m a n a g e r s h a v e t o w r i t e o f f a p a r t o f th e i r

f i r m - s p e c i f i c h u m a n c a p i t a l . H e n c e , t h e m o d e l i s se t up t o c o v e r t w o e l e m e n t s o f

r e s t r u c t u ri n g : ( 1 ) m a n a g e r s a r e p o t e n t i a l l y o p p o s e d t o r e a l l o c a t i n g t h e a s s e t s s i n c e

t h e y h a v e a p r i v a t e s t a k e i n t h e i r c u r r e n t u s e ; a n d ( 2 ) i f m a n a g e r s r e l y o n i m p l i c i t

c o n t r a c t s w h i c h c a n b e b r e a c h e d , t h e n r a t i o n a l l y a n t i c i p a t e d re s t r u c t u r in g s c a n l e a d

t o u n d e r i n v e s t m e n t in h u m a n c a p i t a l. T h e n m a n a g e r s a r e p r o t e c t e d f r o m s u c h a

b r e a c h b y g i v i n g th e m a ll r i g h ts o f c o n tr o l a n d a h i g h - p o w e r e d c o m p e n s a t i o n p l a n

t h at m o t i v a t e s th e m t o m a k e o p t i m a l u s e o f t h e c o m p a n y ' s a s s et s . M a n a g e r s c a n

t h u s b e p r o t e c t e d b y a n e x p l i c i t c o n t r a c t t h a t c a n n o t b e b r e a c h e d , b u t t h i s is n o t

o n l y a v e r y e x p e n s i v e w a y t o i n d u c e c o r r e c t d e c i s i o n s , i t a l s o f a il s t o s o l v e t h e

u n d e r i n v e s t m e n t p r o b l e m . O u t s i d e i n v e s t o r s ( c r e d i t o r s , t a k e o v e r r a i d e r s ) o r a

s u p e r v i s o r y b o a r d o f d i re c t o r s c a n p o t e n t i a l l y a l l e v i a t e t h is p r o b l e m . H o w e v e r , i n

o r d e r to c h e c k m a n a g e r s ' d e c i s i o n s e f f e c t i v e l y t h e y h a v e t o a c q u i r e c o s t l y

i n f o r m a t i o n .

I n d e p e n d e n t d i r e c t o r s a r e a n a l y z e d a s a g e n t s s e p a r a t e f r o m e x e c u t i v e m a n a g e -


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E. Mau g / Journal o f Corporate Finance 3 (1997) 113-139 115

m e n t w h o s e m a i n f u n c t i o n i s t o m o n i t o r a n d r e n e g o t i a t e c o n t r a c t s , b u t w h o a r e n o t

p a r t o f th e p r o d u c t i v e a c t i v i t y o f th e f i r m a s s u c h . I n p a r t i cu l a r , t h e y h a v e n o

v e s t e d i n t e r e s t s i n s p e c i f i c o p e r a t i n g d e c i s i o n s . T h e y a r e a l s o d i f f e r e n t f r o m o t h e r

o u t s i d e s h a r e h o l d e r s b y b e i n g a b l e t o n e g o t i a t e b i l a t e ra l l y w i t h e x e c u t i v e m a n -

a g e rs . D i r e c t o r s ' a b i l i ty t o n e g o t i a te o v e r t h e r e m u n e r a t i o n o f e x e c u t i v e m a n a g e r s

i s c r u c i al t o t h e m o d e l h e r e . T h e y c a n i n d u c e a n o p t i m a l u s e o f th e c o m p a n y ' s

a s s e t s w i t h o u t b r e a c h i n g i m p l i c i t c o n t r a c t s . T h e a r g u m e n t b e l o w e m p h a s i z e s t h e

e s s en t ia l r o l e o f th e i r in d e p e n d e n t j u d g e m e n t . W e a k d i r ec t o rs w h o a r e n o t

i n d e p e n d e n t d o n o t o n l y h a r m s h a r e h o l d e rs t h r o u g h e x c e s s i v e p a y a w a r d s - a n

a s p e c t u s u a l l y e m p h a s i z e d i n t h e p u b l i c d e b a t e - b u t a l so b e c a u s e t h e y r e d u c e t h e

l i n k b e t w e e n p a y a n d p e r f o r m a n c e .

C a p i t a l s t r u c t u r e c a n b e u s e d t o t r a n s f e r c o n t r o l f r o m m a n a g e r s t o s e c u r i t y

h o l d e r s : e i t h e r t o c r e d i to r s i n b a n k r u p t c y , o r to r a id e r s i n t a k e o v e r s . T h e s e

m e c h a n i s m s c a n b e e f f e c t i v e i n r e a l l o c a t i n g r e s o u r c e s . H o w e v e r , t h e y c a n b r e a c h

i m p l i c i t c o n t r a c t s o n w h i c h m a n a g e r s a n d o t h e r s t a k e h o l d e r s i n t h e c o r p o r a t i o n

r e ly w h e n m a k i n g f i r m - s p e c i f ic i n v e s t m e n t s. C o n v e r s e l y , l e ss d i s r u p t iv e m e c h a -

n i s m s l i k e f r i e n d l y t a k e o v e r s m a y f a i l t o p r o v i d e s u f f i c i e n t i n f o r m a t i o n t o o u t -

s i d e rs s o t h a t t h e r e s t r u c t u r i n g p o t e n t i a l o f t h e f i r m i s n o t e x p l o i t e d .

T h e f o l l o w i n g s e c t i o n r e l a te s t h e a r g u m e n t o f t hi s p a p e r t o th e l it e ra t u re . T h e

r e m a i n d e r o f th is p a p e r p r o c e e d s b y d e v e l o p i n g t h e m o d e l a n d d e r i v i n g t h e

f i r s t - b e s t a l l o c a t i o n a s a b e n c h m a r k c a s e ( S e c t i o n 3 ) . S e c t i o n 4 . 1 d i s c u s s e s t h e

c a s e w h e r e m a n a g e r s a r e n o t c o n s t r a i n e d b y o t h e r a g e n t s a n d s u b j e c t o n l y t o a

c o m p e n s a t i o n c o n t r a c t . S e c t i o n 4 . 2 is d e v o t e d t o t h e a n a l y s is o f c o r p o r a t e b o a r d s

a n d p r e s e n t s t h e m a i n r e s u l t s o f th e p a p e r . S e c t i o n s 4 . 3 a n d 4 . 4 i n v e s t i g a t e t o w h a t

e x t e n t c a p i t a l s t r u c t u re c a n s e r v e a s a su b s t i tu t e f o r i n d e p e n d e n t d i r e c t o r s a n d

a n a l y z e t a k e o v e r s a n d d e b t c o n t r a c t s . S e c t i o n 5 d i s c u s s e s e m p i r i c a l i m p l i c a t i o n s

a n d c o n c l u d e s .

2 . D i s c u s s i o n o f th e l i t e r a tu r e

B e r l e a n d M e a n s ( 1 9 3 2 ) p r o v i d e d t h e fi r st c o m p r e h e n s i v e a n a l y s is o f t h e

o r g a n i z a t i o n a l s o l u t i o n s t h a t h a v e b e e n d e v e l o p e d i n o r d e r t o b a l a n c e t h e n e c e s s i t y

o f m a n a g e r i a l d i s c r e ti o n a g a i n s t th e h a z a r d s o f u n c h e c k e d m a n a g e r i a l p o w e r . I n

t h e i r s e m i n a l p a p e r J e n s e n a n d M e c k l i n g ( 1 9 7 6 ) s t r e s s t h e c o n t r o l r i g h t s o f

d i f f er e n t m e m b e r s o f t he c o r p o r a t i o n i n t h e c o n t e x t o f t h e ir ' n e x u s o f c o n t r a c t s ' -

a p p r o a c h . T h i s v i e w w a s f u r t h e r e l a b o r a t e d b y F a m a a n d J e n s e n ( 1 9 8 3 a , b ) w h o

r e l a t e t h e s t r u c t u re o f r e si d u a l c l a i m s t o t h e o r g a n i s a t i o n a l s t r u c t u r e o f t h e f ir m .

T h e i r d i s t in c t i o n b e t w e e n ' d e c i s i o n m a k i n g ' a s a n e x e c u t iv e f u n c t io n , a n d ' d e c i -

s i o n c o n t r o l ' a s a s u p e r v i s o r y t a s k c o r r e s p o n d s t o t h e d i v i s i o n o f t a s k s b e t w e e n

e x e c u t i v e m a n a g e r s a n d i n d e p e n d e n t d i r e c t o r s i n t h e m o d e l p r e s e n t e d i n th i s p a p e r .

T h i s d i s t in c t i o n is a ls o e m p h a s i z e d b y L o r s c h a n d M c I v e r ( 1 9 8 9 ). F o r m a l d i s c u s -

s i o n s o f t h e r o le o f c o r p o r a t e b o a r d s a s d i s ti n c t f r o m e x e c u t i v e m a n a g e m e n t


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116 E. Maug / Journal of Corporate Finance 3 (1997) 113-139

appeared only very recently (Hirshleifer and Thakor (1991, 1994), Warther

(1994)). However, these papers emphasize the role of boards in dismissing

underperforming managers, whereas the model discussed in this paper emphasizes

the role of the board as a negotiator over managerial pay. Berkovitch and Israel

(1996) analyz e the board as an institu tion represen ting different stakeholders.

The literature on the market for corporate control is vast and will not be

discuss ed here. 1 The mos t imp ortant aspect here is the hypothesis of Shleifer and

Summers (1988) that takeover premia are largely explained by transfers of wealth

from corporate stakeholders to shareholders and a breach of implicit contracts (see

Schnitzer (1995) for a formalization of this argument). This paper emphasises the

ex ante incentives to invest in specific skills. These incentives are impaired if

implicit long term contracts are vulnerable to breach in future reorganisations of

the firm, even though the transfers caused by such a breach may be small relative

to other gains from a takeover. 2 The paper adopts the 'substitute hypothesis'

which holds that boards are an alternative mechanism to hostile takeovers. 3

The analysis of debt contracts follows a more recent approach that views debt

as a mech ani sm that allocates control conting ent on the state between insiders

(managers) and outside investors in a world where contracts are incomplete (cf.

Aghion and Bolton, 1992; Zender, 1991). This literature has opened up perspec-

tives which vi ew debt as a device con stra ining managerial discretion (see Hart,

1993; Hart and Moore, 1995; Jensen, 1986). However, such a use of debt causes

problems similar to those with takeovers, since control is assumed by security-

holders who are not bound by implici t contractual arra ngement s.Berk ovitch et al.

(1994) show that bankruptcy law can mitigate this problem.

3 . D e s c r i p t i o n o f t h e m o d e l

Consider a project which has been undertaken in the past and yields a state

cont inge nt payoff y~ where s denotes the state of nature. The payoff y~ depends

on the state which can take on three values, namely H, M, and B

(high/middle/bad). The assets of the project have alternative uses which are not

known until after the state of nature has been revealed. Realizing the returns from

alternative uses requires major restructuring. Restructuring involves redeploymen t

of the assets and their use under a different management. This restructuring

decision will be referred to as a choice between project closure and project

t See Jarrell et al. (1988) for a survey of the empirical iterature and Weston et al. (1990, appx. A),

for a textbook discussionof major theoretical contributions.

2 Empirical studies have not found much evidence for the claim that such transfers of wealth can

explain takeover premia (e.g. Lichtenberg and Siegel, 1990; Rosett, 1990).

3 Cf. Kini et al. (1995) and Shivdasani (1993) for empirical support and Hirshleifer and Thakor

(1991) for a discussionof the alternative complementarityhypothesis'.

i


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E. Maug / Journal of Corporate Finance 3 (1997) 113 139 117

c o n t i n u a t i o n . T h e r e t u r n s f r o m r e s t r u c t u r i n g a r e d e n o t e d b y L ~ ( t h e n Ys = L ~); i f

t h e p r o j e c t i s c o n t i n u e d i t y i e l d s

x s

( th en Ys =

X s ) .

A l l v a l u e s a r e e x p r e s s e d i n

p r i c e s o f s t a g e 1 .

T h e f i r m i s r u n b y m a n a g e r s w h o m a k e h u m a n c a p i t a l i n v e s t m e n t s . T h e h u m a n

c a p i t a l i n v e s t m e n t s c a n b e e i t h e r g e n e r a l o r s p e c i f i c t o t h e f i r m . T h e i n v e s t m e n t i n

h u m a n c a p i t a l i s n o t m o d e l l e d e x p l i c i t l y h e r e . T h i s a s s u m e s t h a t t h e t o t a l a m o u n t

o f in v e s t m e n t i n h u m a n c a p i t a l ( g e n e r a l p l u s s p e c i f i c ) is g i v e n , s o th a t o n l y t h e

c h o i c e o f t h e s p e c i f i c i ty o f h u m a n c a p i t a l n e e d s t o b e c o n s i d e r e d . T h i s s p e c i f i c i t y

o f h u m a n c a p i t a l i s r e p r e s e n t e d b y o n e v a r i a b l e h , w h e r e h l i es i n t h e c l o s e d u n i t

i n t e r v a l a n d c a n b e t h o u g h t o f a s a n i n d e x . T h e f o l l o w i n g a s s u m p t i o n d e s c r i b e s t h e

t e c h n o l o g y o f t h e p ro j e c t : th e s p e c i f i c i t y o f h u m a n c a p i t a l h i n c r e a s e s e x p e c t e d

p r o f i t s , a n d p r o f i t s i n e a c h s t a t e a r e a f f e c t e d b y t h e c l o s u r e d e c i s i o n . T h e l a s t

a s p e c t i s d e t a i l e d f u r t h e r i n A s s u m p t i o n 2 .

A s s u m p t i o n l ( P r o d u c t i o n ) .

( i ) Y s d e p e n d s o n t h e c o n t i n u a t i o n d e c i s i o n :

{L II i f c o n t i n u e d ,

Y~ = i f c lo sed .

( ii ) T h e s p e c i f i c i ty o f m a n a g e r s ' h u m a n c a p i t a l d e t e r m i n e s t h e l i k e l i h o o d o f

m o r e p r o f i t a b l e s t a t e s :

YH

w i t h p r o b ab i li ty p , ( h ) ,

3(, =

YM

w i t h p r o b a b i l i t y I

- - P H ( h ) - - P B , ,

YB w i t h p r o b a b i l i t y P B

w h e r e

p , ( h )

i s i n c r e a s i n g a n d c o n c a v e , h ~ [ 0 ; 1 ] a n d p ~ / ( 0 ) = ~ c, p ~ ( 1 ) = 0 .

( i i i ) x H >

x g > x ~

P a r t s (i ) a n d ( ii ) o f A s s u m p t i o n 1 s u m m a r i z e t h e p r e v i o u s d i s c u s s i o n a n d

i m p o s e s o m e r e g u l a r i t y c o n d i t i o n s . N o t e t h a t t h e p r o b a b i l it y o f th e l o w s t at e B i s

i n d e p e n d e n t o f h . T h i s a s s u m p t i o n f a ci li t at e s p r o o f s a n d i s fo r c o n v e n i e n c e o n l y .

T h e d e f i n i n g c h a r a c t e r i s t i c o f s t at e s i s t h e r a n k i n g o f c o n t i n u a t i o n p r o f i t l e v e l s

x s

i n ( i i i ) . 4 M a n a g e r s a r e r i s k n e u t r a l a n d m a x i m i z e e x p e c t e d u t i l i t y . T h e y n e g o t i a t e

c o n t r a c ts w i th t h e o r i g in a l o w n e r s o f th e f i rm . T h e s e c o n t r a c ts s p e c i f y p a y m e n t s

/ z ( y . ~ ) c o n t i n g e n t o n p r o f i t s . T h e m a n a g e r s d o n o t c a r e a b o u t t h e s p e c i f i c i t y o f

t h e i r h u m a n c a p i t a l i n v e s t m e n t h a s l o n g a s t h e p r o j e c t i s c o n t i n u e d , a n d t h e e f f o r t

f o r in v e s t i n g i n s o m e k i n d o f h u m a n c a p i ta l d o e s n o t n e e d t o b e c o n s i d e r e d h e r e .

H o w e v e r , i n v e s t i n g i n a h i g h l e v e l o f f i r m - s p e c i f i c h u m a n c a p i t a l i m p l i e s t h a t t h e i r

4 The re is no restricti on on the ra nking of L B,

L M

and L H ; cf Ass umpt ion 2 below .


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118 E. Ma ug / Journa l t)f Corporate Finan ce 3 (1997 ) 113-1 39

v a l u e i n t h e o u t s i d e l a b o u r - m a r k e t h a s d e c r e a s e d . 5 I f t h e p r o j e c t i s d i s c o n t i n u e d ,

t h e y s u f f e r a u t i l i t y l o s s

D ( h ) ,

w h i c h i s c o n t i n u o u s , i n c r e a s i n g a n d c o n v e x i n h .

O n e i n t e r p r e t a t i o n o f

D ( h )

i s t h a t m a n a g e r s h a v e l o w e r c a r e e r - p r o s p e c t s i f t h e

h u m a n c a p i t a l th e y h a v e a c q u i r e d i s s p e c i f i c to t h e f ir m r a t h e r th a n o f g e n e r a l

a p p l i c a b i l i t y . A l t e r n a t i v e l y , t h e u t i l it y lo s s m a y b e v i e w e d a s a s e a r c h c o s t t h a t

m a n a g e r s i n c u r i f t h e y h a v e t o l o o k f o r n e w e m p l o y m e n t . 6 Y e t a n o t h e r i n t e rp r e t a -

t i o n is th a t m a n a g e r s ' a v e r s i o n t o r e a l l o c a t i n g t h e a s s e ts i s r e l a t e d to t h e c o m m i t -

m e n t a n d s k i l l t h e y d e v o t e t o t h e p r o j e c t ' s d e v e l o p m e n t . M a n a g e r s ' o b j e c t i v e c an

b e r e w r i t t e n a s

U M = E ( t ~ ( y ~ ) )

- P ( l ) D ( h )

( 1 )

w h e r e E ( . ) d e n o t e s t h e e x p e c t a t i o n s o p e r a t o r a n d P ( I ) t h e p r o b a b i l i t y o f c l o s i n g

t h e p r o j e c t u n d e r p o l i c y 1 . l r e p r e s e n t s t h e s e t o f s t a t e s i n w h i c h t h e p r o j e c t i s

c l o s e d ( e . g . 1 = { B} i n d i c a t e s t h a t i t i s c l o s e d i f a n d o n l y i f s = B ; t h e n P ( 1 ) = P n ;

s i m i l a r l y , i f 1 = { B , M } , t h e n

P ( 1 ) = 1 - P H ) .

T h e f o l l o w i n g a s s u m p t i o n f u r th e r d e f i n e s s t a te s a n d is m a d e i n o r d e r t o

i n t r o d u c e t h e p o s s i b i l i t y o f i n e f f i c i e n t d e c i s i o n s a b o u t t h e u s e o f t h e a s s e t s .

A s s u m p t i o n 2 ( S t a t e s ) .

( i ) L H - - x H < O

( i i ) D ( O ) > L M - x M > O

( i i i )

0 < D ( I ) < L ~ - x n

( i v ) ( p n ( l ) - - P u ( 0 ) ) ( x n - - x M ) < p s ( L , - x , ) .

( s t a t e H ) ,

( s t a t e M ) ,

( s t a t e B ) ,

I n s t a te H , n o b o d y w o u l d c o n s i d e r c l o s i n g a p r o j e c t. I n s ta t e M , i t i s p r i v a t e l y

b u t n o t s o c i a l l y o p t i m a l t o r e s t ru c t u r e s i n c e t h e g a i n s d o n o t e x c e e d t h e p e c u n i a r y

e q u i v a l e n t o f t h e u t i l i t y - l o s s t h e y i n f l i c t o n m a n a g e r s . I n s t a te B , i t is p r i v a t e l y a n d

s o c i a l l y o p t i m a l t o r e d e p l o y t h e a s s e ts . O n l y t h e s e t h r e e s i t u a t io n s m a t t e r s i n c e

t h e y d e s c r i b e t h e c o n f l i c t o f in t e r e s t b e t w e e n o w n e r s a n d m a n a g e r s . O u t s i d e r s w h o

m a k e d e c i s i o n s c o n t in g e n t o n p e c u n i a r y r e tu r n s o n l y w i ll re s t ru c t u re w h e n e v e r

L - x > 0 e v e n i f t h i s d i f f e r e n c e i s r e l a t i v e l y s m a l l .

A s s u m e t h a t h i s o b s e r v a b l e b u t n o t c o n t r a c t i b l e . T h e n m a n a g e r s c a n n o t i n s u r e

t h e m s e l v e s a g a i n s t p r o j e c t c l o s u r e b y w r i t i n g c o m p e n s a t i o n p a y m e n t s i n t o t h e i r

c o n t r a c t s c o n t i n g e n t o n h . T h e o n l y w a y i n w h i c h t h e y c a n p r o t e c t t h e m s e l v e s i s

b y i n v e s t i n g i n g e n e r a l h u m a n c a p i t a l i n o r d e r t o li m i t th e i r e x p o s u r e t o r e s tr u c t u r -

i n g - d e c i s i o n s t a k e n b y o u t s i d e r s (i .e . k e e p i n g t h e i r o p t i o n s o p e n o n t h e m a n a g e r i a l

5 For academ ics, research is usually a non-institution specific activity, whereas teaching skills are

more institution specific.

6 I am grateful to R obert Heinkel for this interpretation.


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E. Maug Journal of Corporate Finance 3 (1997) 113 139 119

2. 3. 4. 5.

I I I I t P o e

O w n er s deter mine Ma nage r choose s Sta te o f natu r e s Par ty in con t r o l Payof ts ). ,, r ea l ized ;

gover na nce s t r uctu r e : speci f ic i ty o f r evealed decides abou t par t ies paid accor d ing to

cap i la l s t r uclu r e hum an cap i ta l h p r o ject c losur e con t r acts ; mana ger s

man ager ia l con t r act paid ,u ( y , )

d e c i s i o n m a k i n g r i g h t s

Fig. 1.

l a b o u r m a r k e t ) . T h i s w i ll , h o w e v e r , m a k e t h e p r o j e c t l e ss s u c c e s sf u l . M o r e o v e r ,

c o n d i t i o n ( i v ) e n s u r e s t h a t t h e r e s t r u c t u r i n g g a i n i s s u f f i c ie n t l y i m p o r t a n t r e l a t i v e

t o p o t en t ia l e f f i c i e n c y - g a i n s f r o m h u m a n c a p i ta l i n v e s t m e n t s t o m a k e c l o su r e i n

s t a te B a l w a y s a t t r a c t i v e . T h e t i m i n g o f t h e m o d e l i s d i s p l a y e d i n F i g . 1.

T h e n e x t p r o p o s i t i o n d e r i v e s t h e f i r s t- b e s t a l l o c a t io n ( l * , h * ) a s a b e n c h m a r k

f o r f u rt h e r r e s ul t s . I t i s d e f i n e d f r o m t h e m a x i m a n d :

m a x 1I = ~ p , ( h ) y., - P ( l ) D ( h ) . ( 2 )

{ I ,h } s ~ { H , M , B }

R e c a l l t h a t P ( 1 ) d e n o t e s t h e p r o b a b i l i t y o f re d e p l o y i n g t h e a s se t s u n d e r p o l i c y

I. T h e f ir s t t e r m g i v e s p r o fi t s a s a f u n c t i o n o f h a n d f o l l o w s i m m e d i a t e l y f r o m

A s s u m p t i o n 1. T h e s e c o n d t e r m i s t h e e x p e c t e d d i s u t i l i t y m a n a g e r s s u f f e r ( cf . E q .

( 1 )) . T h i s o b j e c t i v e c a n b e i n t e r p re t e d a s t h e p r o f i t - m a x i m i z a t i o n - p r o b l e m o f a n

o w n e r u n d e r t h e a s s u m p t i o n t h a t h a n d / a r e c o n t r a c t i b l e a t s t a ge 1. T h e f o l l o w i n g

p r o p o s i t i o n c h a r a c t e r i z e s t h e fi r s t - b e st , w h e r e h * d e n o t e s t h e f ir s t -b e s t i n v e s t m e n t

i n p r o j e c t - s p e c i f i c h u m a n c a p i t al : 7

Proposition 1 (Firs t-best ). The solution of prog ram (2) which characterizes the

first -best is to liquidate a project if and only if it is in state B. The firs t-bes t value

h* E (0 , 1 ) is inter ior and unique and soh, es:

p~( h )( x H - x M) -p aD '( h* ) = 0 . ( 3 )

I a s s u m e t h r o u g h o u t t h e p a p e r t h a t w e a l t h - c o n s t r a i n t s a re s u f f i c i e n t l y s e v e r e

s u c h t h a t o u t s i d e f i n a n c e is r e q u i r e d a n d c o n t r o l h a s t o b e d e l e g a te d . I a l s o a s s u m e

t h a t h i s n o t c o n t r a c t i b l e . T h i s i n t r o d u c e s a d i f f e r e n c e b e t w e e n t h e ex ante

o b j e c t i v e ( 2 ) , a n d t h e ex post p e r s p e c t i v e w h e r e o u t s i d e rs h a v e a n i n c e n t i v e to

d i s re g a r d m a n a g e r s ' i n v e s t m e n t in h u m a n c a p i ta l .

7 All proofs are available in the long version o f this paper and are not included here to econom ize on

space. The lu l l version of the paper can be downloaded from the web page 'h t tp : / /w w w. du ke .ed u/ ~

maug/research/boarddir/ ' . You can also obtain a hardcopy from the author upon request. Please see

title page for mailing address.


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1 2 0

E . M a u g / J o u r n a l ( ~f O ~ r p o r a t e F i n a n c e 3 ( 1 9 9 7 ) 1 1 3 1 3 9

4 . A n a l y s is o f a lt e r n a t i v e o r g a n i z a t i o n a l f o r m s

T h e q u e s t i o n o f w h i c h o r g a n i z a t i o n a l f o r m i s o p t im a l i s a n a l y z e d i n t h e

r e m a i n d e r o f t h is p a p e r . T h e b a s i c d i s ti n c t i o n h e r e is b e t w e e n m a n a g e r s a n d

o u t s i d e r s . M a n a g e r s a r e i n c o n t r o l a n d b y v i rt u e o f th e i r i n v o l v e m e n t i n t he

o p e r a t i o n s o f t he f i r m h a v e s u f f i c i e n t i n f o r m a t i o n t o i d e n t i f y a n y r e s t r u c t u r i n g

p o t e n t i a l t o i n c r e a s e s h a r e h o l d e r v a l u e . A l t e r u a t i v e l y , o u t s i d e p a r t i e s c a n b e g i v e n

c o n t r o l r i g h t s , b u t a n y o u t s i d e r o t h e r t h a n t h e i n c u m b e n t m a n a g e m e n t n e e d s t o

a c q u i r e a d d i t i o n a l c o s t l y i n f o r m a t i o n i n o r d e r t o r e a l i z e t h e r e s t r u c t u r i n g p o t e n t i a l

o f t h e f i r m :

A s s u m p t i o n 3 ( R e s t r u c t u r i n g b [ b r m a t i o n ). A n o u t s i d e p a r t y c a n r e a l i z e t h e

r e s t r u c t u r i n g p o t e n t i a l o f t h e f i r m o n l y i f it h a s i n v e s t e d i n a d d i ti o n a l i n f o r m a t i o n .

T h i s i n f o r m a t i o n i s o b t a i n e d w i t h p r o b a b i l i t y T . i n f o r m a t i o n a c q u i s i t i o n i s c o s t l y

w i t h i n f o r m a t i o n a c q u i s i t i o n c o s t s C (~ -). T h e c o s t f u n c t i o n s a ti s fi e s C ' ( ~ - ) > 0 ,

C " ( - r ) > 0 and C ( 0 ) = 0 . M a n a g e r s o b s e r v e t h is i n f o r m a t i o n w i t h o u t i n c u rr i n g a n y

a d d i t i o n a l c o s t s .

N o t e t ha t st a te s i s s ti ll a s s u m e d t o b e c o m m o n k n o w l e d g e . H o w e v e r , i n o r d e r

t o r e a l i z e t h e d i f f e r e n c e L , - x , . , m o r e d e t a il e d o p e r a t i n g k n o w l e d g e o f th e f i r m i s

r e q u i r e d . W h e r e a s m a n a g e r s , w h o o p e r a t e t h e f ir m o n a d a y t o d a y b a s i s a re

a s s u m e d t o p o s se s s t h is k n o w l e d g e , a n y o u t si d e p a r t y w h o w a n t s t o i m p r o v e t h e

o p e r a t i o n s o f th e f i r m h a s t o a c q u i re it. E a c h o r g a n i z a t i o n a l s t r u c t u r e m u s t

d e t e r m i n e t w o e l e m e n t s : m a n a g e r i a l c o m p e n s a t i o n a n d t h e i m p l i e d c l o s u r e p o l i c y ,

w h i c h d e p e n d s a l s o o n t h e i n c e n t i v e s o f o u t s i d e r s t o a c q u i r e i n f o r m a t i o n . O r g a n i -

z a t i o n a l f o r m s a r e c h a r a c t e r i z e d a s f o l l o w s :

M a n a g e r i a l c o n t r o l

D i r e c t o r s

D e b t

T a k e o v e r s

M a n a g e r s ' c o m p e n s a t i o n c o n t r a c t is f i x e d b y t h e in i ti a l o r g a -

n i z a t i o n a l d e s i g n e r a n d o n l y m a n a g e r s h a v e c o n t r o l o v e r

c l o s u r e . ( S e c t i o n 4 . 1 )

M a n a g e r s d e c i d e o n c l o s u r e p o l i c y ; d i r e c t o r s h a v e c o n t r o l

o v e r m a n a g e r i a l r e m u n e r a t i o n a n d c a n u s e t h is t o a f f e c t

c l o s u r e - p o l i c y . ( S e c t i o n 4 . 2 )

I f t h e f i rm is s o lv e n t , o n l y m a n a g e r s h a v e c o n t r o l . I n

b a n k r u p t c y s t a t e s o n l y d e b t h o l d e r s h a v e c o n t r o l o v e r t h e

a s s e t s . D e b t h o l d e r s d o n o t g e t i n v o l v e d i n d e t e r m i n i n g m a n -

a g e r i a l p a y . ( S e c t i o n 4 . 3 )

A t a k e o v e r r a i d e r c a n a c q u i r e c o n t r o l o f th e a s s e t s o f th e f i r m

a n d c a n o f f e r m a n a g e r s s e v e r a n c e p a y m e n t s . ( S e c t i o n 4 . 4 )

E a c h o f t h e s e o r g a n i z a t i o n a l f o r m s i s a n a l y z e d a s a n a l t e r a ti o n o f s ta g e 4 o f th e

e x t e n s i v e f o r m o f t h e g a m e ( c f. F i g . 1 ).

, i , ~ I i , , i T l ' r l I ,


9/27

E . M a u g / J o u r n a l ( ? [' Co rp or at e F i n a n c e 3 ( 1 9 9 7 ) 1 13 1 3 9 121

4 . 1. E x p l i c i t c o n t r a c t u a l p r o t e c t io n : P u r e m a n a g e r i a l c o n t r o l

P u r e m a n a g e r i a l c o n t r o l is t he s i m p l e s t o r g a n i z a t io n a l f o rm a n d r e s e m b l e s a

c l a s s i c a l p r i n c i p a l - a g e n t s i t u a t i o n , M a n a g e r s a r e f u l l y p r o t e c t e d b y a n e x p l i c i t

c o n t r a c t s i n c e t h e y e x e r c i s e a l l c o n t r o l r ig h t s o v e r t h e u s e o f th e a s s e t s . T h e n t h e

o n l y w a y t o o b t a i n t h e g a i n s f r o m r e s t r u c t u r i n g i s a c o m p e n s a t i o n - s c h e m e t h a t

g i v e s m a n a g e r s a n i n c e n t i v e t o c l o s e t h e p r o j e c t i n t h e l o w s t a t e . M a n a g e r s '

c o m p e n s a t i o n c a n b e a n y p r o f i t c o n t i n g e n t c o n tr a c t / z (y s ) . M a n a g e r s h a v e z e r o

i n i ti a l w e a l t h s o t h a t th e c o n t r a c t c a n n o t i n v o l v e n e g a t i v e p a y m e n t s i n a n y s t a te ,

i .e . / ~ ( y ~ ) > = 0 f o r a l l y ~,. S i n c e m a n a g e r s h a v e n o w e a l t h t h e y w i l l n o t b e m a d e

r e s i d u a l c l a i m a n t s ; s i n c e t h e y a r e r i s k n e u t r a l t h i s m u s t b e r u l e d o u t , o t h e r w i s e t h e

s o l u t i o n o f th e p r o b l e m w o u l d b e t r i v i a l. D e n o t e b y h E t h e d e g r e e o f s p e c i f i c i t y o f

h u m a n c a p i t a l f o r t h e c a s e o f e x p l i c i t c o n t r a c t u a l c o v e n a n t s , a n d b y r t h e r en t

m a n a g e r s e x t r a c t , d e f i n e d a s t h e d i f f e r e n c e b e t w e e n t h e i r e x p e c t e d u t i l i t y a n d t h e i r

r e s e r v a t i o n u t i l i t y , a s s u m e d t o b e z e r o .

P r o p o s i t i o n 2 ( P u r e m a n a g e r i a l c o n t r o l ) . ( i ) T h e o p t i m a l m a n a g e r i a l c o n t r a c t

u n d e r p u r e m a n a g e r i a l c o n t ro l h a s :

{ ~

h E )

if y.~ = LB.

/ ~ (y ~ ) = ( X H ) > 0 i f y , = X u . ( 4 )

i f y.~ 4= L B , x , ,

w h e r e 0 < I~ ( X # ) < x ~ - x g . i ~ ( x H ) a n d hF, s a t i s ~ :

~ ( x u ) p ' ( h E ) = p e D ' ( h F )

( 5 )

f r o m m a n a g e r s ' f i r s t - o r d e r c o n d i ti o n s . T h i s i n d u c e s r e st r u c tu r i n g i [ a n d o n l y ( f

s = B a n d u n d e r i n v e s t m e n t i n p r o j e c t - s p e c if i c h u m a n c a p it a l: h E < h * .

( i i ) M a n a g e r s o b t a i n a s t r ic t l y p o s i t i v e r e n t :

r = I ~ ( x H ) P H ( h E ) .

( 6 )

H e n c e , t h e o p t i m a l c o n t r a c t c o m p r i s e s ( 1 ) a s e v e r a n c e p a y m e n t i n c a s e o f

l i q u i d a t i o n ( a ' g o l d e n p a r a c h u t e ' ) , a n d ( 2 ) a b o n u s p a y m e n t i n t h e h ig h s t a t e H .

T h e l a tt e r c o u l d b e i m p l e m e n t e d t h r o u g h a s t o c k o p t i o n s c h e m e w i t h e x e r c is e

p r i c e X e q u a l t o M a x ( L B , x M ) a n d g r a n t i n g t ~ ( X H ) / ( X H - - X ) o p t i o n s . / ~ ( Z ~ ) i s

p o s i t i v e i f i t i n d u c e s t h e m a n a g e r e i t h e r t o c l o s e t h e p r o j e c t o r to i n v e s t i n m o r e

s p e c i f i c h u m a n c a p i t a l . I t f o l l o w s f r o m A s s u m p t i o n 2 t h a t l iq u i d a t i o n i s o p t i m a l

w h e n e v e r s =

B ,

h e n c e t h e m a n a g e r i s p a i d f o r l i q u i d a t i n g i n t h i s s t a t e . A n

i n c r e m e n t a l i n c r e a s e i n h i n c r e a s e s p r o f it s b y

p ' u ( h ) ( x H - x M )

f r o m A s s u m p t i o n

1 , s o t h a t p r o f i t s h a r i n g i n s t a te s = H b e n e f i t s i n i t i a l o w n e r s ; n e v e r t h e l e s s ,

m a n a g e r s a r e n o t m a d e r e s i d u a l c l a i m a n t s , o t h e r w i s e o w n e r s w o u l d s u r r e n d e r a l l

b e n e f i t s t o t h e m , s o t h a t / ,z ( x

n ) < x H - x g

a n d h E < h * . S i n c e m a n a g e r s h a v e n o


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122 E. M au g / Jou rna l (~["Corporate Fin ance 3 (1997) 113 -13 9

r e s o u r c e s , t h e y c a n n o t p a y f o r t h e v a l u e o f t h i s s h a r e a n d o b t a i n a re n t . I n v i e w o f

P r o p o s i t i o n 2 , p r o f i t s / / F i n t h e c a s e o f p u r e m a n a g e r i a l c o n t r o l a re :

/ / F ~ = y ' p ~ ( h e ) x ., + p ~ ( L ,~ - x B ) - r . ( 7 )

.s

H e n c e , i n s e t ti n g / x ( x H ) o w n e r s t r ad e o f f t h e b e n e f i t f r o m h i g h e r p r o f i ts o f th e

f i rm a g a i n s t t he r e n t s th e y h a v e t o p a y m a n a g e r s i n o r d e r t o i m p l e m e n t a c e r ta i n

v a l u e f o r h . S i n c e t h e s e r e n t s i n c r e a s e i n h , a s u b o p t i m a l v a l u e h e < h * i s c h o s e n .

T h e w e a k n e s s o f p r o t e c t i n g m a n a g e r s b y e x p l i c i t c o n t r a c t s is t h a t m a n a g e r s d o n o t

s i gn a n e m p l o y m e n t c o n t ra c t c o n t i n g e n t on h a n d h a v e t o b e m o t i v a t e d b y a b o n u s

p a y m e n t ~ ( x , ) i n t h e h i g h st at e. T h e n e x t s e c t i o n i n t r o d u c e s a n o w n e r s h i p - s t r u c -

t u r e w h i c h p o t e n t i a l l y o v e r c o m e s t h i s p r o b l e m .

4 .2 . I n d e p e n d e n t d i r e c t o r s

T h i s o w n e r s h i p - s t r u c t u r e i n t r o d u c e s a n o t h e r a g e n t w h i c h I c a l l a s u p e r v i s o r y

b o a r d o f d i re c t o r s o r s i m p l y i n d e p e n d e n t d ir e c to r s . F o r t h e p u r p o s e o f t h is

a r g u m e n t i t i s i m m a t e r i a l w h e t h e r i n d e p e n d e n t d i re c t o r s a r e a p a r t o f a u n i t a r y

b o a r d , o r f o r m a se p a r a t e s u p e r v i s o r y b o a r d i n a tw o - t i e r s y s t e m , s U n l i k e

m a n a g e r s , d i r e c to r s d o n o t i n v e s t i ll f i r m - s p e c i f i c h u m a n c a p i ta l , b u t t h e y h a v e t o

b e m o t i v a t e d t o a c q u i r e i n f o r m a t i o n a b o u t a l t e r n a t iv e o p e r a t i n g p o l ic i e s a c c o r d i n g

t o A s s u m p t i o n 3 . D i re c t o rs m a x i m i z e e x p e c t ed u t i li ty . T h e i r c o m p e n s a t i o n - s c h e m e s

m u s t b e l i n e a r p a y m e n t s w h i c h m a y b e c o n t i n g e n t o n t h e n e t p r o fi t s o f t h e f ir m n e t

o f m a n a g e r s ' c o m p e n s a t i o n . T h e y n m s t b e o f t h e fo r m

7 ( Y , - # ( Y . ~ )) ( 8 )

L i k e m a n a g e r s , d i r e c t o rs h a v e n o i n i t ia l w e a l t h , h e n c e t h e y c a n n o t p a y f o r t h e i r

s h a re s o u t o f t h e ir o w n w e a l t h . 9 D i r e c t o r s ' m o t i v a t i o n c a n b e u n d e r s t o o d i n t h r e e

w a y s . F i r s t, t h e y m a y b e o b l i g e d t o h o l d y s h a r e s o f t h e f i rm w h i c h e n t i t le s th e m

t o a f r a c t i o n 7 i n t h e d i v i d e n d y.~ - / , ( y , ). m S e c o n d , t h e y m a y b e u n d e r a

f i d u c i a r y d u t y t o s h a r e h o l d e r s t o a c t o n t h e i r b e h a l f . I n t h is c o n t e x t s u c h a d u t y

w o u l d o b l i g e t h e m t o m a x i m i z e t o t al p a y o u t s . L a s t, t h e y m a y w a n t t o a c q u i r e a

g o o d r e p u t a t i o n a s i n d e p e n d e n t m o n i t o r s i n o r d e r to g a i n m o r e d i r e c to r s h i p s i n th e

f u t u re . ~t T h e m o d e l l i n g a p p r o a c h h e r e r e l ie s e x c l u s i v e l y o n t h e m o t i v a t i o n o f

d i r e c to r s t h r o u g h s h a r e h o l d i n g s o r i n c e n t i v e c o n t r a c t s c o n f o r m i n g to (8 ). W h e r e a s

s One might argue that separate supervisory boards are more likely to be independent. See Monks

and Minow (1995) for a textbook treatment of corporate governance institutions.

9 Situations where directors are or represent lar ge shareholders would have to be co vered b y a

different analysis. The discussion here refers to the typical situation of externally appointed directors

whose wealth is small relative to the size of the firm.

10 Cf. L inn and M artin (1994) for an em pirical documen tation of the stoc k ownership o f directors.

ii Cf. Fama (1980) for a detailed exposition of this hypothesis and Kaplan and Reishus (1990) and

Gilson (1990) for supporting empirical evidence.


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E. Mtmg Journal of Corporate Finance 3 (1997) 113-139 123

a l l t h r e e a p p r o a c h e s i m p l y t h a t d i r e c t o r s ' i n c e n t i v e s w i l l b e a l i g n e d w i t h t h o s e o f

s h a r e h o l d e r s , o n l y t h e g r a n t i n g o f f r e e s h a r e s t o d i r e c t o r s i m p l i e s t h a t t h i s c o m e s a t

a d i r e c t c o s t t o i n i t i a l s h a r e h o l d e r s , m o t i v a t i n g t h e d o u b l e a g e n c y p r o b l e m

a n a l y z e d h e r e . T h e a s s u m p t i o n o n l i n e a r i t y i s a s i m p l i f i c a t i o n . I t w i l l b e s h o w n

b e l o w ( S e c t i o n 4 . 3 ) t h a t g r a n t i n g d i r e c t o r s o p t i o n s o r l e v e r i n g t h e f i r m w o u l d

i m p r o v e t h e a l l o c a t i o n . H o w e v e r , l i n e a r i t y d o e s n o t a f f e c t a n y o f t h e q u a l i t a t i v e

i n s i g h t s d i s c u s s e d i n t h i s s e c t i o n .

U n d e r t h i s o w n e r s h i p - s t ru c t u r e , m a n a g e r s h a v e t h e r i g h t to d e c i d e a b o u t t h e u s e

o f th e a s s e t s . D i r e c t o r s h a v e t h e r i g h t to r e v i e w m a n a g e r s ' s a l a r ie s . F o r c l a r i ty ,

d e n o t e t h e o r i g i n a l m a n a g e r i a l c o n t r a c t a g r e e d a t s ta g e 1 b y i~o(Z,) a n d t h e

c o m p e n s a t i o n o f f e r e d b y d i r e c to r s b y /2 . D i r e c t o r s c a n i n f l u e n c e c l o s u r e d e c i s io n s

b y o f f e r i n g m a n a g e r s a d d i t i o n a l c o m p e n s a t i o n f o r d i v e s t i n g . H e n c e , m a n a g e r s

n e g o t i a t e w i t h d i r e c to r s o v e r t h e c l o s u r e d e c is i o n a n d o v e r a d e q u a t e c o m p e n s a t i o n .

4.2.1. Full control by independent directors

T h e m a i n t a i n e d a s s u m p t i o n o f t h is s u b s e c t i o n ( t o b e r e l a x e d b e l o w ) i s t h a t

d i r e c t o r s h a v e a l l t h e b a r g a i n i n g p o w e r w h e n t h e y n e g o t i a t e m a n a g e r s ' c o m p e n s a -

t i o n . W h e n e v e r d i r e c t o r s w a n t t o r e d e p l o y a s s e t s t h e y o f f e r m a n a g e r s a c o m p e n s a -

t i o n / 2 i n r e t u r n f o r t h e i r c o n s e n t t o t h i s d e c i s i o n . T h e e x t e n s i v e f o r m o f s t a g e 4

( s e e F ig . 1 a b o v e ) i s th e n t h e f o l l o w i n g s t y l iz e d b a r g a i n i n g g a m e :

( a ) D i r e c t o r s o f f e r m a n a g e r s a c o m p e n s a t i o n /2 s u b j e c t t o t h e i r c o n s e n t to a s se t

r e a l l o c a t i o n s .

( b ) M a n a g e r s a c c e p t o r r e j e c t t h i s o f f e r .

( c ) I f t h e y re j ec t , t h e o r ig i n a l m a n a g e r i a l c o n t r a c t is i m p l e m e n t e d , m a n a g e r s

r e c e i v e ~ 0 (Y ~ ) a n d n o a s s e t c a n b e s o l d . I f t h e y a c c e p t , t h e y r e c e i v e /2 a n d

d i r e c t o r s d e c i d e w h e t h e r t o l i q u i d a t e o r n o t .

T h e f i r m i s f u l l y e q u i t y f i n a n c e d , b u t e q u i t y h o l d e r s h a v e n o d e c i s i o n m a k i n g

r i g h t s o t h e r t h a n t h e i n it i al a p p o i n t m e n t o f d i r e c to r s . P r o p o s i t i o n 3 d e s c r i b e s t h e

a l l o c a t i o n .

Propositi on 3 (Direct ors). Assum e control is delegated to managers and direc-

tors. Di rectors can identiD restructuring possibilit ies at a cost as defined in

Assumption 3. They retain all bargaining power in negotiations with management,

but managers have a veto right over the use of the assets. Then:

(i) Directors hold a frac tion t~D of the equity and identify the restructuring

potential o f the fir m with probabili ty rD. If director s are informed, mana gers

receive a trans fer /2 = D( h* ) in state s -- B and zero transfers in the other two

states. There are no prof it-c ontingen t payments, i.e. /~0(Y~) = 0 .for all Z,. The

optimal values rD and YD are unique and related as

YD = ps ( L 8 _ x8 _ D( hD) ) ( 9 )


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E. Maug /Journal ~[ Colporate Finance 3 (1997) 113-139

T h e s p e c i fi c i ~ , o f h u m a n c a p i t a l h t~ a n d t h e s et ~ e ra n c e p a y m e n t t o m a n a g e r s

D( hl> ) a re d ec re as in g in ~-L~, a nd "rt> is in c re as ing in YD.

( i i ) I f

C ' ( I )

a n d

C ( 1 )

a r e s m a l l a n d PB l a r g e e n o u g h , t h is m e c h a n i s m

i m p l e m e n t s t h e f i r s t - b e s t a l l oc a t i on w i t h h o = h * . I f C '( ~ 't ~) i s s u f f i c i e n t l y l a r g e

a n d p e s u f f ic i e n t ly s m a l l, t h e n t h i s m e c h a n i s m l e a d s t o a l o w e r e x a n t e pa y o ff " t o

i n it ia l s h a r e h o l d e r s t h a n p u r e m a n a g e r i a l c o n t r o l.

S t a n d a r d b a r g a i n i n g t h e o r y i m p l i e s t h a t d i r e c t o r s w i l l o f f e r m a n a g e r s a l w a y s

e x a c t l y D ( h ) i f t h e y p r o p o s e t o c l o s e t h e p r o j e c t , s o t h at t h e n e t e c o n o m i c g a i n

f r o m c l o s u r e , L R - x B - D ( h ) a c c r u e s e n t i r e l y t o s h a r e h o l d e r s , w h e r e a s m a n a g e r s '

u t i l it y r e m a i n s u n c h a n g e d t h r o u g h b a r g a i n i n g a n d i s u n a f f e c t e d b y c lo s u r e .

T h e r e f o r e , d i r e c t o r s c h o o s e t h e l iq u i d a t i o n p o l i c y w h i c h m a x i m i z e s t h e n e t g a i n ,

a n d m a n a g e r s ' s e v e r a n c e p a y m e n t a l w a y s e x a c t l y o f fs e t s th e i r u t i l i ty - l o s s i f t h e

p r o j e c t i s c l o s e d , t h e r e b y g i v i n g t h e m f u l l i n s u r a n c e a g a i n s t e x p r o p r i a t i o n . A s a

r e s u l t, t h e l i k e l i h o o d o f th e c l o s u r e d e c i s i o n h a s n o i m p a c t o n t h e i r d e c i s i o n t o

i n v e s t i n s p e c i fi c h u m a n c a p i t a l , a n d t h e y c a n i n v e s t th e e q u i l i b r i u m a m o u n t ht~

w i t h o u t a p o s it i v e b o n u s p a y m e n t . O n e w a y o f im p l e m e n t i n g s u c h a n e g o t i a ti o n

g a m e w o u l d h a v e o n e i n d e p e n d e n t d i r e c t o r le s s th a n t h e n u m b e r o f v o t es r e q u i re d

t o d e c i d e o n a s s e t s a l es . O b s e r v e t h a t d ir e c t o r s a c t a s a g e n t s o f s h a r e h o l d e r s i n t h a t

t h e y m a x i m i z e e x a n t e s h a r e h o l d e r w e a l t h . E x p o s t , s h a r e h o l d e r s w o u l d p r e f e r t o

r e n e g e o n t h e c o n t r a c t a n d c l o s e i n s t a t e s = M a s w e l l .

H o w e v e r , t h e b e n e f i t s o f r e s t ru c t u r i n g c o m e a t a c o s t to s h a r e h o l d e r s , s i n c e

t h e y h a v e t o m o t i v a t e d i r e c t o r s t o b e c o m e i n f o r m e d . F r o m E q . (9 ) , t h e k e y

v a r i a b l e i s t h e

m a r g i n a l

c o s t o f i n f o r m a t i o n , s i n c e t h i s d e t e r m i n e s t h e d e g r e e t o

w h i c h d i r e c t o r s b e c o m e i n f o r m e d f o r a g i v e n f ra c t i o n o f t h e e q u i t y t h e y h o l d . I f

t h e m a r g i n a l c o s t f o r b e c o m i n g i n f o r m e d i s r e l a t i v e l y m o d e s t , t h e n y ~ a n d t h e

c o s t s t o s h a r e h o l d e r s , w h i c h a r e YD ~ , P.~ Y .~, a r e l o w e n o u g h , s o t h a t d i r e c t o r s w i l l

b e g i v e n i n c e n t i v e s to b e c o m e p e r f e c t l y i n f o r m e d ( T = 1). T h i s r e q u i r e s a l s o th a t

t h e c o s t f u n c t i o n i s n o t t o o c o n v e x ( C ( h ) i s sm a l l ) , s i n c e t he e x a n t e t r a d e o f f is

b e t w e e n a n i n c r e m e n t a l i n c r e a s e i n ~- a n d t h e b e n e f i t s o f s u p e r v i s i o n , a n d a n

i n c r e m e n t a l i n c r e a s e i n c o s t s , (i . e . a n i n c r e a s e i n y a n d t h e r e f o r e C ' ( ~ -) ) . C o n -

v e r s e l y , i f t h e c o s t s o f p r o v i d i n g d i r e c t o r s w i t h i n c e n t i v e s a r e t o o l a r g e , t h e n t h e

b e s t s o l u t io n w h i c h c a n b e a c h i e v e d w i t h t h is m e c h a n i s m i s s t il l d o m i n a t e d b y

p u r e m a n a g e r i a l c o n t ro l . W h e r e a s s h a r e h o l d e r s p a y t h e c o s t s o f c o n t r o l t h r o u g h

d i r e c t o r s i n a l l st a te s o f t h e w o r l d , t h e y o b t a i n t h e b e n e f i ts o n l y i n th e b a d s t a te

s = B . H e n c e , d i r e c t o r s b e c o m e m o r e a d v a n t a g e o u s i f PH i s l a r g e r. A l s o , i f

d i r e c t o r s h a v e s t r o n g e r i n c e n t i v e s , t h e n ( 1 ) t h e i n c i d e n c e o f r e s t ru c t u r i n g i n c r e a s e s

b e c a u s e ~- i n c r e a s e s , a n d t h e r e f o r e ( 2 ) t h e i n v e s t m e n t i n s p e c i f i c h u m a n c a p i t a l b y

t h e m a n a g e r i s r e d u c e d . ~-~

12 This result is related to the entrenchment argument by Shleifer and Vishny (1989). However, here

managers respond to the possible breach of implicit contracts. There is no sense in which they actively

entrench themselves by making themselves indispensable.

. . . . . . T . . . . . . . . T . . . . . . .


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E. Ma ug / Journa l o[' Corporate Fina nce 3 (1997 ) 113-13 9 125

The first-best result is somewhat special but instructive, since it reveals the

essential elements of the dire ctor-mechanis m very clearly. In order to understand

better the distinctive features of the director-mechanism and the importance of

negotiation, compare directors with any randomly chosen large shareholder who

owns a share o- of the firm and has the right to trigger liquid ation of the project

but is not allowed to change managers' remuneration. Managers are protected by a

severance package which gives them a golden parachute G if they are dismissed.

This setup is similar to the direct or-me chani sm except that the negotia tion elem ent

is removed. This leads to the following:

P r o p o s it io n 4 ( R a n d o m sh a r e h o l d e r ) . A s s u m e a r a n d o m l y c h o s e n s h a r e h o l d e r

o w n s a s h a r e o" o f t h e f i r m a n d h a s t h e r i g h t to i n it ia t e l i q u id a t i o n a n d m a n a g e r s

h a t ,e a s e t~ e ra n c e p a c k a g e w h i c h p a y s t h e m a g o l d e n p a r a c h u t e G ~ f t h e y a r e

d i s m i s se d . T h e n t h e a ll o c a t io n c a n b e i m p r o~ , ed f o r a l l p o s s i b l e p a r a m e t e r s b y

a l s o g i l d i n g t h i s s h a r e h o l d e r t h e r i g h t t o r e n e g o t i a t e m a n a g e r i a l c o m p e n s a t i o n .

Note that this result does not assume that the golden parachute G and the stake

of the random shareholder cr are in any sense optimally chosen. This result

illuminates why directors' discretion over managers ' severance package, and

hence the negotiation aspect of the director-mechanism is crucial: it makes

severance pay c onti ngent on h, so that the allocation is dependent on the

non-contractabl e variable h. A managerial contract which automatically grants an

ex ante fixed severance payment in case of dismissal cannot replace this since it

replaces a payme nt which is conti ngen t on h by one which is not. This phe-

nomenon is familiar from the literature on the hold-up problem. 13

Note that several assumptions about directors are important for the result to

obtain which define a director as an i nstitution which com bines elements of

managers and elements of ordinary shareholders. They are similar to shareholders

in that they aim to increase pecuniary payoffs to shareholders only. 14 They are

different from shareholders because they are conferred additional property rights

(determine operating decisions, managerial compensation) and they bear additional

costs to make informed decisions. Directors are different from executive manage-

ment because they have no vested interests in particular operating decisions.

Specifically, they have no specific human capital at stake in case of project

closures. This may be regarded as the d e f i n i t i o n of an independent director.

Directors whose human capital is so specialized that it gives them a stake in a

13 Cf. Hermalin and Katz (1991) for a proof of a general theorem for a principal agent contract.

Aghion et al. (1994) and Hart and Moore (1995) discuss alternative renegotiation settings and the

implicationsfor the underinvestment roblem. Other contributions nclude Hubermanand Kahn (1988),

Chung (1991) and MacLeod and Malcomson(1993).

14 Byrd and Hickman (1991) and Linn and Martin (1994) find that shareholdings of independent

directors increase the performance of corporate boards.


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1 2 6 E. Ma u g / Jo u rn a l ~ / ' C o rpo ra te F in a n ce 3 (1 9 9 7 ) 1 1 3-1 39

p a r t i c u l a r d e c i s i o n a r e n o t i n d e p e n d e n t a n d s h o u l d b e c l a s s e d a s e x e c u t i v e

m a n a g e m e n t . D i r e c t o r s w h o a r e r e p r e s e n t a t i v e s o f a f f i li a t e d c o m p a n i e s a r e a l s o

n o t i n d e p e n d e n t i n t h e s e n s e r e q u i r e d ( s e e S e c t i o n 4 . 2 . 2 b e l o w ) . L a s t l y , d i r e c t o r s

a r e a s s u m e d t o h a v e a l l t h e n e g o t i a t i n g p o w e r v i s a v i s m a n a g e r s . T h i s i s a s t r o n g

a s s u m p t i o n a n d i ts r e l a x a t io n i s t h e s u b j e c t o f t h e n e x t s e c t io n .

4.2 .2 . Manager ia l negot ia t ing power

T h e p o s i t i v e r e s u lt a b o u t i m p l e m e n t a t i o n o f th e f i rs t - b e s t w i th t h e d i r e c t o r -

m e c h a n i s m i s o b v i o u s l y e x t r e m e a s i t d e p e n d s o n a l l b a r g a i n i n g - p o w e r b e i n g

g i v e n t o d i r e c to r s . H o w e v e r , a s d i r e c t o r s n e e d m a n a g e r s ' c o n s e n t i n o r d e r t o f o r c e

r e s t r u c t u r in g a n d b e c a u s e t h e y h a v e t o r e n e g o t i a te t h e i r s al a ry , m a n a g e r s m a y b e

t o s o m e d e g r e e s u c c e s s f u l i n p r e s s i n g f o r a h i g h e r c o m p e n s a t i o n t h a n i s n e e d e d t o

m a k e t h e m j u s t i n d i f f e r e n t b e t w e e n c o n t i n u a t i o n a n d c l o s u r e o f t h e p r o j e c t . T h i s

s e c t i o n t h e r e f o r e a n a l y z e s t h e s a m e o w n e r s h i p - s t r u c t u r e a s t h e p r e v i o u s s e c t i o n

u n d e r a l t e r n a t i v e a s s u m p t i o n s o n b a r g a i n i n g p o w e r . H e n c e , t h e e x t e n s i v e f o r m o f

s t a g e 4 o f t h e g a m e i s n o w :

( a ) D i r e c t o r s a n d m a n a g e r s b a r g a i n o v e r t h e d e c i s i o n t o c l o s e t h e f i r m a n d o v e r

m a n a g e r s ' s a l a r y .

( b ) I f t h e y r e a c h an a g re e m e n t , m a n a g e r s r e c e iv e a t r a n s f e r / 2 a n d i m p l e m e n t t h e

a g r e e d r e s t r u c t u r i n g d e c i s i o n . I f th e y d o n o t a g r e e m a n a g e r s d e c i d e a n d

r e c e i v e t h e p a y m e n t f r o m t h e i r o r i g i n a l c o n t r a c t / ~ 0 .

15

T h e b a r g a i n i n g o u t c o m e i s d e t e r m i n e d f r o m :

A s s u m p t i o n 3 ( B a r g a i n i n g ) . I f m a n a g e r s a n d d i r e c t o rs e n t e r a b a r g a i n i n g g a m e

a t s t a g e 4 , t h e n t h e o u t c o m e i s d e t e r m i n e d a c c o r d i n g t o a g e n e r a l i z e d N a s h -

b a r g a i n i n g s o l u t i o n w h i c h g i v e s d i r e c t o r s b a r g a i n i n g - p o w e r 1 - ce a n d m a n a g e r s

b a r g a i n i n g - p o w e r c ~ .

I t i s a l m o s t i m p o s s i b l e t o p r e s c r i b e i n a n y k i n d o f e x p l i c i t c o n t r a c t t h e

b a r g a i n i n g - p o s i t i o n s o f i n s i d e rs w h o w o r k i n c l o s e r e l a t io n s h i p s , l et a lo n e f o r m a l -

i z e s u c h a b a r g a i n i n g - p r o c e s s . T h e a p p r o a c h a d v o c a t e d h e r e is t o t a k e ' b a r g a i n i n g

p o w e r ' a s e x o g e n o u s l y g i v e n r a t h er t h a n t o m a k e i t p a r t o f t h e f o rm a l m o d e l .

R e s e a r c h e r s o f c o rp o r a t e g o v e r n a n c e h a v e a n a l y z e d d e t e rm i n a n t s o f th e r e la t iv e

p o s i t i o n s o f d i re c t o r s v e r s u s e x e c u t i v e s . L o r s c h a n d M c I v e r ( 1 9 8 9 ) i d e n t i f y in

p a r t i c u l a r ( 1 ) t h e n o m i n a t i o n p r o c e s s o f d i r e c t o r s ( s e l e c t e d b y t h e C E O o r an

i n d e p e n d e n t c o m m i t t e e ) , ( 2 ) t h e i r l e g a l a c c o u n t a b i l i t y , a n d ( 3 ) t h e i r a c c e s s t o

15 F o r a t e x t b o o k t r e a t m e n t o f th e g e n e r a l i z e d N a s h b a r g a i n i n g - s o l u t i o n s e e B i n m o r e ( 1 9 9 2 , c h . 5 ) .

T h e c o o p e r a t i v e s o l u t io n c h o s e n h e r e i s d i r e c tl y r e l a te d t o n o n - c o o p e r a t i v e b a r g a i n i n g s o l u t io n s a n d t h e

s o l u t io n b e l o w h a s a n i n t e rp r e t a ti o n i n t e r n ls o f a l t e r n a t i n g o f fe r g a m e s ; c f . O s b o r n e a n d R u b i n s t e i n

( 1 9 9 0 , c h . 4 ) f o r a d i s c u s s i o n .

.... T ~' ~ - - ~ ~'~r - 't -*


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127

i n d e p e n d e n t i n f o r m a t i o n a l s o u r c e s . T h e l a s t a r g u m e n t w o u l d i m p l y t h a t c o s t s C ( ~ -)

a n d c~ a r e p o s i t i v e l y c o r r e l a t e d . B a y s i n g e r a n d B u t l e r ( 1 9 8 5 ) e m p h a s i z e t h e

d i f f e r e n c e b e t w e e n a f f i l i a te d o u t s i d e d i r e c t o r s w h o r e p r e s e n t o r g a n i s a t i o n s w i t h

f i n a n c i a l o r b u s i n e s s r e l a t i o n s h i p s w i t h t h e f i r m a n d i n d e p e n d e n t d i r e c t o r s . T h e y

f i n d t h a t f i r m s w i t h a s t r o n g e r i n d e p e n d e n t e l e m e n t p e r f o r m o n a v e r a g e b e t t e r . ~ 6

D i r e c t o r s r e c e i v e i n c a s e o f c l o s u r e T ( L ~ - / 2 ) a n d in c a se o f n o c lo s u r e

y(x,- txo(x,)) .

S i m i l a r l y , m a n a g e r s g e t / x0 (X ~ .) i n c a s e o f c o n t i n u a t i o n a n d

/ 2 - D ( h )

i n c a s e o f c l o s u r e . H e n c e , t h e m a x i m a n d f o r t h e g e n e r a l i z e d N a s h

B a r g a i n i n g g a m e i s

q ~ ( h , / 2 , a ) { T ( L , . x ~ / 2 + , x , ( , ,~,

- - tZol, X , ) ) j * { / 2 - / . % ( x ) - O ( h ) }

(lO)

T h e n :

/ 2 ( o ~, h ) - a r g m a x ~ p( h , / 2 , c ~ ) . ( 1 1 )

#

T h e r e s u l t i s e x p r e s s e d i n t h e f o l l o w i n g p r o p o s i t i o n .

Proposition 5 (Bargainin g Power). (i) Suppose Assumption 3 holds and man-

agers have bargaining powe r c~. Then the fir m will be closed if and only (f

directors have acqu ired information and the fi rm is in state s = B. Directors

award managers a transfer/2 contingent on c and h given by

/ 2( ce, h ) = , , , ( x s )

+ D( h) c~( L~ - x R - D( h ))

( 1 2 )

and /2 = tXo in all other states.

(ii) If c~ > O, the director-mechani sm does not imple ment the firs t-best allo-

cation anymore fo r any fo rm of C(T). The payoff to original owners is monotoni-

cally decreas ing in c~ and there exists a critical value fo r e~, ceMc with

0 < c~Mc < 1 such that the dir ector-mechan ism dominates p ure manager ial con-

trol i f 0 < c~


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128 E. Maug / Journal qf Cotporate fTnance 3 (1997) 113 139

T h e i n t u it i o n b e h i n d t h e s e c o n d p a r t o f t h e r e s u lt i s t h a t d ir e c t o r s w h o d o n o t

h a v e s u f f i c i e n t b a r g a i n i n g - p o w e r a g a i n s t m a n a g e m e n t d o n o t o n l y b e c o m e l e s s

u s e f u l , b u t p o s i t i v e l y h a r m f u l s i n c e t h e y w o r s e n m a n a g e r s ' i n c e n t i v e s t o i n v e s t i n

p r o j e c t - s p e c i f i c h u m a n c a p i t a l . T h i s i s s o m e w h a t s u r p r i s i n g b e c a u s e m a n a g e r s '

c o m p e n s a t i o n i n r e s t r u c t u r i n g - s t a t e s i n c r e a s e s w i t h t h e i r b a r g a i n i n g - p o w e r . 17

I n s p e c t i o n o f E q . (1 1 ) r e v e a l s w h y t h is l e a d s t o a n i n f e r io r a l l o c a t i o n . F i r s t - o r d e r

c o n d i t i o n s f o r c h o o s i n g h in t h e d i r e c t o r - m e c h a n i s m a r e:

~ ( x H ) ~ , ; ( h ) = ~ r p B D ' ( h ) . ( 1 3 )

I f m a n a g e r s h a v e m o r e b a r g a i n i n g p o w e r , t h ei r c o m p e n s a t i o n d e p e n d s m o r e o n

t h e i r n e g o t i a t i n g s k i l l s t h a n o n t h e i r p e r f o r m a n c e , i . e . t h e i r i n v e s t m e n t i n s p e c i f i c

h u m a n c a p it al . T h i s r e m o v e s t h e a d v a n t a g e o f t h e d i re c t o r - m e c h a n i s m o f m a k i n g

t h ei r c o m p e n s a t i o n c o n t i n g e n t o n t h e i r i n v e st m e n t . T h e n t h e d i r e c t o r - m e c h a n i s m i s

s i m i l a r t o p u r e m a n a g e r i a l c o n t r o l i n t e r m s o f in c e n t i v e s b u t t o t al t r a n s f e rs a r e

l a r g e r s i n c e m a n a g e r s r e c e i v e l a r g e r r e n t s . I t i s t h i s d o u b l e h a z a r d w h i c h d i r e c t o r s

w i t h l o w b a r g a i n i n g - p o w e r i n t r o d u c e : t h e y a w a r d e x c e s s i v e s a l a r i e s t o m a n a g e r s ,

c a u s i n g a d i r e c t l o s s t o s e c u r i t y - h o l d e r s , a n d t h e y w e a k e n t h e l i n k b e t w e e n p a y

a n d p e r f o r m a n c e , t h e r e b y c a u s i n g a n i n d i re c t l o s s i n t h e f o r m o f p r o d u c t i v e

i n e f f i c i e n c i e s . T h e t w o t a k e n t o g e t h e r l e a d t o t h e u n i f o r m v e r d i c t e x p r e s s e d i n

P r o p o s i t i o n 5 ( i i ) .

4 .3 . C o n t r o l a n d c a p i t a l s t r u c t u r e : D e b t a n d c r e d i t o r c o n t r o l

T h e p r e v i o u s s e c t i o n h a s s h o w n t h a t i n d e p e n d e n t d i r e c t o r s h a v e t h e p o t e n t i a l t o

i m p l e m e n t t h e f ir s t b e s t i f t h e i r n e g o t i a t i n g p o s i t i o n i s v e r y s t r o n g , o t h e r w i s e a n

i n d e p e n d e n t s u p e r v i s o r y b o a r d m a y b e a m i x e d b l e s s i n g . U n d e r s u c h c i r c u m -

s t a n c es , m a n a g e r i a l d i s c r e t i o n m a y b e c h e c k e d b y c r e d i t o r s o r r a i d er s . T h e

c i r c u m s t a n c e s u n d e r w h i c h t h e y g a i n c o n t r o l o f t h e f ir m a r e d e t e r m i n e d b y t h e

c a p i t a l s t r u c t u r e a n d t h e c o r p o r a t e c h a r t e r . T h e s e m e c h a n i s m s a r e d i s c u s s e d i n t h i s

s e c t i o n i n o r d e r t o i n v e s t i g a t e a l t e r t m t i v e s t o t h e i n t e r n a l c o n t r o l s t r u c t u r e s

a n a l y z e d a b o v e . T h e f i r s t s u b s e c t i o n s h o w s h o w l e v e r a g e c a n c o n s t r a i n m a n a g e r i a l

d i s c r e t io n , w h e r e a s t h e s e c o n d s u b s e c t i o n f o c u s e s o n th e m a r k e t f o r c o r p o r a t e

c o n t r o l a s a n e x t e r n a l d i s c i p l i n i n g d e v i c e .

A s s u m e n o w t h a t o w n e r s h i p r i g h t s c a n b e t r a n s f e r r e d t o s e c u r i t y - h o l d e r s b y

u s i n g p r o f i t - c o n t i n g e n t d e b t . i . e . a f i n a n c i a l c o n t r a c t w h i c h s p e c i f i e s t h a t c o n t r o l o f

t h e f i r m i s t r a n s f e r r e d t o c r e d i t o r s i f p r o f i t s f a l l b e l o w a c e r t a i n v a l u e ( s e e b e l o w ) .

i f c r e d i t o r s h a v e t h e r i g h t t o l i q u i d a t e , t h e y w i l l a l w a y s l i q u i d a t e a t t = 1 i f

L , - x , .

> 0 , i . e . t h e y w i l l o n l y c o n s i d e r p e c u n i a r y r e t u r n s . S u p p o s e t h e f a c e v a l u e

o f d e b t F s a t is f ie s x B < F < x a 4 . T h e n i n s ta t e B , t h e f i r m i s b a n k r u p t a n d

c r e d i t o r s g a i n c o n t r o l o v e r t h e a s se t s , w h e r e a s i n s t at e M t h e f i r m is s ti ll s o l v e n t .

17 See e .g. B erkovitch et al. (1 994 ) whe re the f irs t best is implem ented only if the man ager

(entrepreneur) has

all

the b argaining power.

. . . . . T . . . . T


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E. Maug / Journal of Corporate Finance 3 (1997) 113-139 129

W h a t h a p p e n s i n c a s e o f c r e d i t o r c o n t r o l d e p e n d s c r i t i c a ll y o n th e i n f o r m a t i o n

c r e d i t o r s h a v e i n c a s e o f b a n k r u p t c y . S u p p o s e t h a t t h e d e b t i s o w n e d b y a b a n k .

S u p p o s e t h e b a n k e x p e c t s t o g a i n c o n t r o l o f t h e a ss e t s i f a n d o n l y i f s = B . T h e n

t h e e q u i l i b r i u m l e v e l o f s o l v e s

C ' ( ~ ) = p ~ ( L B - x 8 - D ( h ) ) . ( 1 4 )

N o t e t h a t t h i s i s a n a l o g o u s t o E q . ( 9 ) a b o v e . E v i d e n t l y , b o r r o w i n g f r o m a b a n k

w i l l b e c o s t l y i n t h i s m o d e l , s i n c e t h e b a n k w i l l n e e d t o r e c o v e r t h e i n f o r m a t i o n

c o s t s i n o r d e r t o b r e a k e v e n . T h e f o l l o w i n g p r o p o s i t i o n p r e s e n t s t h e m a i n r e s u l t o n

c r e d i t o r c o n t r o l ; h o d e n o t e s t h e l e v e l o f h c h o s e n b y t h e m a n a g e r i f o w n e r s h a v e

c h o s e n t h e o p t i m a l d e b t l e v e l .

P r o p o s i t io n 6 ( D e b t ) . ( i ) T w o d e b t - p o li c ie s c a n b e e x a n t e o p t i m a l f o r o w n -

ers."

1. l = {B }: t he . f i r m w i l l b e c l o s e d i n s t a t e s = B ;

2 . 1 = {M , B}: t he f i r m w i l l b e c l o s e d i n s t a t e s s = M an d s = B .

( i i ) I f t he c os t s o f ac q u i r i ng i n f o r m a t i on C ( ~ ' ) a r e s u f f i c i e n t l y l ow , t he n th i s

s o l u t i o n g i v e s i n i ti a l o w n e r s h i g h e r p r o f i t s t h a n p u r e m a n a g e r i a l c o n t r o l a n d i s

d o m i n a t e d b y t h e d i r e c t o r - m e c h a n i s m a s c h a r a c t e r i z e d i n P r o p o s i t i o n 3 ; t h e

s o l u t io n i n v o l v e s u n d e r i n v e s t m e n t i n p r o j e c t - s p e c i f i c h u m a n c a p i ta l : h D < h * .

( i i i ) I f t h e c o s t o f i n f o r m a t i o n a c q u i s i t i o n a r e s u f fi c i e n tl y h ig h , t h e n d e b t i s

d o m i n a t e d b y p u r e m a n a g e r i a l c o nt ro l .

( i v ) If" t he p r ob ab i l i ~ o f r e s t r uc t u r i n g i n t he l ow s t a te P B is s u f f i c i e n t l y l ow ,

t h e n d e b t d o m i n a t e s t h e d i r e c t o r - m e c h a n i s m .

E v e n t h o u g h o w n e r s c a n r e d u c e t h e r e n t m a n a g e r s c a n e x t r a c t r e l a t i v e t o p u r e

m a n a g e r i a l c o n t r o l , i n v e s t m e n t i n s p e c i f i c h u m a n c a p i t a l r e m a i n s i n e f f i c i e n t ,

R e c a l l f r o m P r o p o s i t i o n 2 t h a t u n d e r m a n a g e r i a l c o n t r o l m a n a g e r s o b t a i n a s t r i c t l y

p o s i t i v e r e n t ( g i v e n b y E q . ( 6 ) ) . H e n c e , w h e n e v e r o w n e r s d e t e r m i n e t h e o p t i m a l

d e b t - p o l i c y , t h e y h a v e t o o b s e r v e t w o c o n s t r a i n t s : f i r s t , m a n a g e r s ' i n c e n t i v e

c o m p a t i b i l i t y c o n s t r a i n t w h i c h r e q u i r e s :

tX( Xn ) P 'n( hD ) = P ( I ) D ' ( hD ) ( 1 5 )

a n d s e c o n d , t h e i r p a r t i c i p a t i o n c o n s t r a i n t w h i c h a m o u n t s t o t he i r r e n t r b e i n g

n o n - n e g a t i v e . F r o m A s s u m p t i o n 2 ( i i ) , i t c a n n e v e r b e p r o f i t a b l e t o l i q u i d a t e i n

s t a te s = M i f t h is r e q u i r e s a n a d d i t i o n a l p a y m e n t D ( h D ) t o t h e m a n a g e r i n t h a t

s t at e . H o w e v e r , s u p p o s e m a n a g e r s r e c e i v e a s t r i ct l y p o s i t i v e r e n t i f 1 = { B } . T h e n

l i q u i d a t i n g i n s ta t e s = M a s w e l l g i v e s o w n e r s p M ( L M - - x M ) m i n u s t h e e f f i -

c i e n c y l o s s f r o m a h i g h e r p r o b a b i l i t y o f p r o j e c t c l o s u re . T h i s e f f i c i e n c y l o s s i s

P ' n ( h ) ( x H - x M ) A h t o a f i r s t - o r d e r a p p r o x i m a t i o n , w h e r e A h i s t h e r e d u c t i o n i n h

b e c a u s e m a n a g e r s e x p e c t a h ig h e r p r o b a b i li t y o f p r o j e c t cl o s u re . N o a s s u m p t i o n o n

t h e p a r a m e t e r s o f th e m o d e l p r e v e n t s t h e n e t g a i n f r o m b e i n g p o s i t i v e , a n d

1 = { M , B } i s a n o p t i m a l p o l i c y i f t h e n e t g a i n is p o s i t i v e a n d m a n a g e r s ' p a r t i c ip a -


18/27


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E. Maug Journal of Corporate Finance 3 (1997) 113-139 131

o w n e r s , t h e y w i ll c h o o s e a h i g h e r y i f t h e y c h o o s e a h i g h e r le v e r a g e F , h e n c e

d i r e c t o r ' s s h a r e h o l d i n g s a n d l e v e r a g e s h o u l d b e p o s i t i v e l y c o r r e l a te d . I t s h o u l d b e

o b s e r v e d t h a t i m p l e m e n t i n g t h i s s o l u t i o n w i t h d e b t i s n o t t h e o n l y p o s s i b i l i t y .

D i r e c t o r s c o u l d e q u a l l y w e l l r e c e i v e o p t i o n s o r w a r r a n t s w i t h s u f f i c i e n t l y h i g h

e x e r c i s e p r i c e s t o g e n e r a t e t h e s a m e r e s u l t .

A n o t h e r l i te r a t u re o n d e b t h a s e m p h a s i z e d t h e a b i li t y o f l e n d e r s t o r e n e g o t i a t e

f i x e d c l a i m s , t h e r e b y i n c r e a s i n g t h e f l e x i b i li t y o f d e b t c o n t r a c t s . ~s H o w e v e r , d e b t

r e n e g o t i a t i o n i m p r o v e s e f f i c i e n c y m o s t l y t h r o u g h a v o i d i n g e x p o s t i n e f f i c i e n t

l i q u i d a t i o n , w h e r e a s t h e m o d e l h e r e i m p l i e s l i q u i d a t i o n s w h i c h a r e e x a n t e , b u t n o t

e x p o s t i n e f f i c i e n t . A l s o , d e b t r e n e g o t i a t i o n t y p i c a l l y s e r v e s t o a d j u s t f i n a n c i a l

c l a i m s a g a i n s t t h e c o m p a n y t o a l l o w c o n t i n u a t i o n a s a g o i n g c o n c e r n , a n d n o t t h e

a d j u s t m e n t o f e x e c u ti v e c o m p e n s a t i o n t h r o u g h c r e d i to r s .

4.4. TakeoL~ers and the role of the corporate charter

A s s u m e t h e f i r m i s f u l l y e q u i t y f i n a n c e d a n d a t le a s t a c e r t a i n p a r t o f th e

o u t s t a n d i n g s h a r e s h a v e v o t i n g r ig h t s . T h e n u m b e r o f o u t s t a n d i n g s h a r e s is

n o r m a l i z e d t o 1 . S u p p o s e a f t e r s t a g e 3 a p o t e n t i a l r a i d e r c a n t a k e o v e r t h e

c o m p a n y a n d b i d f o r t h e v o t i n g r ig h ts . M o r e o v e r , a s s u m e t h e r a id e r c a n a c q u i re a

f r a c t i o n ~b o f t h e f ir m a t th e c u r r e n t m a r k e t p r i c e P , w h e r e P i s t h e e x d i v i d e n d

v a l u e o f t h e s h a r e s a t s t a g e 3 b e f o r e a b i d i s a n n o u n c e d . E v i d e n t l y , b i d d e r s a r e

o n l y i n t e r e s t e d i n p e c u n i a r y p a y o f f s , l e a v i n g m a n a g e r s v u l n e r a b l e t o i n t e r v e n t i o n s

b y o u t s i d e rs w h o d o n o t ta k e i n t o a c c o u n t t h e l o s s th e y m a y s u f f er i f t h e ir h u m a n

c a p i t a l is d e p r e c i a te d . C o n s i d e r t h e r e f o r e t h e i n c l u s i o n o f t a k e o v e r d e f e n s e s i n t h e

c o r p o r a t e c h a r t e r w h i c h o w n e r s d e c i d e a t t h e fi r s t s t e p o f th e g a m e . H e n c e , s t a g e 4

o f t h e g a m e d e s c r i b e d i n S e c t i o n 2 h a s t h e f o l l o w i n g e x t e n s i v e f o r m :

( a ) A p o t e n ti a l ra i d e r d e c i d e s w h e t h e r t o b e c o m e i n f o r m e d a b o u t t h e f i rm a n d

t a k e i t o v e r o r n o t . I f n o t , m a n a g e r s d e c i d e a b o u t t h e u s e o f t h e a s s et s .

( b ) I f t h e r a i d e r b e c o m e s i n f o r m e d a n d d e c i d e s t o t a k e o v e r h e p u r c h a s e s ~b

s h a r e s o n th e s t o c k m a r k e t a t t h e c u r r e n t m a r k e t p r i c e P a n d a n n o u n c e s t h e

c o n d i t i o n s o f t h e b i d .

( c ) M a n a g e r s d e c i d e w h e t h e r t h e y u se t a k e o v e r d e f e n s e s i f s u c h d e fe n s e s a re

a v a i l a b l e t o t h e m .

( d ) I f m a n a g e r s d e f e n d t h e b i d s u c c e s s f u l l y , t h e y s t a y i n c o n t r o l a n d d e c i d e a b o u t

t h e u s e o f th e a s s e ts . I f t h e y d o n o t d e f e n d t h e b i d , s h a r e h o l d e r s d e c i d e

w h e t h e r t o t e n d e r t h e i r s h a r e s ,

( e ) I f t h e b i d s u c c e e d s , t h e ra i d e r g a in s c o n t r o l a n d d e c i d e s h o w t o u s e t h e a s se t s.

O t h e r w i s e m a n a g e r s s t a y i n c o n t r o l a n d m a k e d e c i s i o n s .

O n l y s t a t e s w h e r e L ~ > x~ a r e c a n d i d a t e s f o r t a k e o v e r s . T h e r a i d e r w i l l c l o s e

t h e f i r m , r e d e p l o y t h e a s s e t s a n d o b t a i n L ~ . H e n c e , t h e p o s t a n n o u n c e m e n t v a l u e

is Cf. Bolton and Scharfstein (1996) and Rajan (1992).


20/27

1 3 2 E . M a u g / J o u r n a l q [ ' C o r p o ra t e F i n a n c e 3 ( 1 9 9 7) 1 1 3 - 1 3 9

o f t h e s h a r e i s L ~. S h a r e h o l d e r s w i l l te n d e r t h e i r s h a r e s o n l y i f t h e r a i d e r o f fe r s

L ~ , o t h e r w i s e t h e y w o u l d p r e f e r t o s t a y a s m i n o r i t y s h a r e h o l d e r s i n t h e f i r m a n d

t h e b i d w o u l d f a i l . ~9 D e n o t e b y q t h e p r o b a b i l i t y t h a t a t a k e o v e r b i d i s m a d e i f

t h e r a i d e r i s i n f o r m e d . T h i s i s a l s o t h e m a r k e t ' s e x p e c t a t i o n o f a b i d i n e q u i l i b -

r iu m . T h e n , b e f o r e t h e a n n o u n c e m e n t o f th e b i d th e v a l u e o f t h e c o m p a n y a n d t h e

m a r k e t p r i c e o f th e s h a r e i s P =

q ' r L , +

(1 -

q~' )x~ .

T h e r a i d e r ' s p r o f i t s a r e

R = 4 ) ( L s - P ) = 05 (1 -

q r ) ( L , - x , ) .

( 1 6 )

H e n c e , t h e r a i d e r w i l l t a k e o v e r w h e n e v e r R >_ 0 w h i c h r e q u i r e s

L,.

> x ~ . N o t e

t h a t R > 0 i m p l i e s t h a t th e r a i d e r a l w a y s b i d s a n d q = 1. T h e r a i d e r o b t a i n s t h e

p r o f i t R w i t h p r o b a b i l i t y r . T h i s g i v e s t h e f i rs t r e s u l t o n h o s t i l e o r u n d e f e n d e d

t a k e o v e r s :

P r o p o s i t i o n 8 ( H o s t i l e t a k e o v e r s ): I f t a k e o v e r s a r e u n d e f e n d e d , a b i d w i l l

a l w a y s b e m a d e w h e n e v e r t h e r a i d e r h a s b e c o m e i n f o r m e d a n d s = M o r s = B .

T h e r a i d e r b e c o m e s i n f o r m e d w i th p r o b a b i l i ty ~-R < 1 / 2 w h i c h s o l v e s :

M a x ~ & T e ( 1 - - T n ) ( p s ( L s - - x B ) + p M ( L M - - X M ) ) - - C ( T e ) .

( 1 7 )

M a n a g e r s r e c e i v e o n l y a p a y m e n t ~[" t h e s t a t e i s h i g h ( x H - x M > t z ( x n ) > 0 ) .

O n e i m p l i c a t i o n o f t h i s r e s u l t is t h a t th e r e m a y b e t o o f e w t a k e o v e r s a n d t h e

r e s t r u c t u r i n g p o t e n t i a l

L ~ - x B

m a y n o t b e r e a l i z e d i f t h e s t a k e t h e r a i d e r c a n

a c q u i r e i n t h e m a r k e t i s t o o s m a l l . F i r s t - o r d e r c o n d i t i o n s a r e:

05(1

- - 2 T n ) ( p B ( L n - - x s ) + p M ( L M - - X M ) ) = C ' ( T R )

( 1 8 )

a n d i m p l y t h a t r e < 1 / 2 . I f 05 i s s m a l l , r R i s g o i n g t o b e s m a l l a n d t h e i n c i d e n c e

o f t a k e o v e r s i s lo w .

I f th e r a i d e r i s s u f f i c i e n t ly i n f o r m e d , t a k e o v e r s l e a d t o e x c e s s i v e a s s e t r e a l l o c a -

t i o n b e c a u s e t h i s i s o p t i m a l a f t e r s t a g e 3 w h e n t h e d e c i s i o n a b o u t h u m a n c a p i t a l i s

s u n k a n d m a n a g e r s c a n n o t b r i b e p o t e n t i a l r a i d e r s . T h i s s i t u a t i o n p r o v i d e s a

r a t i o n a l e f o r t a k e o v e r d e f e n s e s w h i c h g i v e m a n a g e r s s o m e c o n t r o l o v e r t h e

t a k e o v e r p r o c e s s . T h e r e a r e n u m e r o u s s t r a t e g i e s t o d e f e n d b i d s . 20 S i n c e t a k e o v e r

d e f e n s e s a r e n o t t h e f o c u s o f th i s d i s c u s s i o n , n o a n a l y s i s o f t h e m e c h a n i c s o f

d i f f e r e n t d e v i c e s i s u n d e r t a k e n h e r e . A s s u m e f o r t h e r e m a i n d e r o f th i s s e c t io n t h a t

m a n a g e r s h a v e a c c e s s t o s o m e e f f e c t i v e d e f e n s e ( e . g . a p o i s o n p i l l ) , a n d t h a t a

r a i d e r c an o n l y a c q u i r e c o n t r o l o f th e a s s e t s b y o b t a i n i n g m a n a g e r s ' c o n s e n t f o r

t h e t ra n s a c t i o n . A l s o , s u p p o s e t h e c o r p o r a t e c h a r t e r c o u l d i n c l u d e a c l a u s e

s p e c i f y i n g th a t a n y s e v e r a n c e p a y r e c e i v e d b y t h e m a n a g e r i n th e e v e n t o f a

t a k e o v e r is p a i d o u t o f t h e c o m p a n y ' s c a s h f l o w s a n d t h a t th e r e is s u f f ic i e n t

19 T h i s i s f a m i l i a r fr o m t h e a n a l y s i s o f t h e f re e r i d e r p r o b l e m , c f . G r o s s m a n a n d H a r t ( 1 9 8 0 ) .

~0 S e e W e s t o n e t a l. ( 1 9 9 0 , c h . 2 0 ) f o r a t e x t b o o k t r e a t m e n t o f t a k e o v e r d e f e n s e s , a n d H e r z e l a n d

S h e p r o ( 1 9 9 0 , c h . 1 . 8) , f o r a d i s c u s s i o n f r o m a l e g a l p o i n t o f v i e w .


21/27

E. Maug / Journal of Corporate Finance 3 (1997) 113 139

133

c o m p e t i t i o n i n th e m a r k e t f o r c o r p o r a t e c o n t r o l . T h i s c o u l d b e a c h i e v e d w i t h

e x c l u s i o n d e v i c e s l i k e r e s t ri c t e d o f f e r s o f th e k i n d d i s c u s s e d i n G r o s s m a n a n d H a r t

( 1 9 8 0 ) . A l t e r n a t i v e l y , t h e b i d d e r c o u l d o f f e r t h e t a r g e t s h a r e h o l d e r s h a r e s i n th e

m e r g e d f i r m i n s t e a d o f c a s h ( a 1 0 0 % p a p e r o f f e r) . T h i s w o u l d a l s o p a s s o n t h e

b i d d i n g c o s t s t o t h e t a r g e t s h a r e h o l d e r s .

P r o p o s i t i o n 9 . A s s u m e a s u c c e s s f u l b i d d e r i s p

boards of directors and capital structure

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