Transcript Corporate Governance

Corporate Governance
Introduction
• More general thing than financial contracting
– Shleifer and Vishny: “corporate governance deals
with the ways in which the suppliers of finance to
corporations assure themselves on getting a return on
their investment”
– Tirole: interests of stakeholders other than investors
should also be taken into account
– Most generally (Zingales): CG is a set of mechanisms
that shape relationships between all parties to a firm.
Ideally, this set should provide the parties with
incentives to do ex-ante efficient investments (not
necessarily monetary) and ensure efficient bargaining
ex-post
Pledgeable income and efficiency
• From the “traditional” (Shleifer and Vishny)
perspective the goal of corporate governance is
to maximize “pledgeable income” (at the lowest
cost)
• “Pledgeable income”: how much (in expected
terms) the manager can credibly promise to
return to investors.
• The greater it is the more confident investors are
in getting their money back, hence, the more
willing they are to invest in positive NPV projects
Basic framework
Financing
stage
Project costs I.
Entrepreneur has
A<I;
borrows at least I-A
Moral hazard
stage
Choice of probability
of success: p+Δp
(no private benefit)
or p (private benefit B)
Outcome
stage
Verifiable profit:
X{0, XH};
Pr[X=XH] = either
p+Δp or p
Assume (p+Δp)XH – I > 0, but pXH – I < 0
Incentive scheme: E gets w if success, 0 if failure.
Incentive compatibility (no private benefit extraction): Δpw ≥ B
Setting w at B/Δp, we get that the maximum (gross) return the
investors can get, given IC holds:
(p+Δp)(XH – (B/Δp))
Hence, financing is feasible iff
(p+Δp)(XH – (B/Δp)) ≥ I – A
i.e. pledgeable income exceeds the investors’ outlay
• The basic idea of “corporate governance” can be viewed
as increasing pledgeable income through the reduction
of private benefits
• It should be done in the least costly way (optimal
combination of the corporate governance mechanisms)
Mechanisms
• Executive compensation
– Rationale: aligning managers’ objectives with the
shareholders’ interests  need for compensation
based on stock price and other measures of
performance (shares, stock-options, bonuses)
– Has risen in the US since 1970, especially due to a
rise in the use of stock options in 90’s  high payperformance sensitivity (in the US equity based
compensation is on average 50-60% of the total
compensation)
– But is it an outcome of optimal contracting? Evidence
suggests that maybe not, managers can pay
themselves too much because they capture the
process of setting compensation
– Stock-based compensation involves costs: e.g. short
termism, excessive risk (stock options), insufficient
effort (stock options), earnings manipulation…
Mechanisms (cont-d)
• Board of directors
– Supposed to protect shareholders and
oversee management
– In reality is often captured by the
management or controlling shareholders
– Hence, in theory, need for “independent”
directors
– But overall empirical evidence yields very
ambiguous conclusions about the effects
board composition on firm value
Mechanisms (cont-d)
• Large investors: monitoring and control
– Reduce (discourage) managerial opportunism
(self-dealing)
– But involve costs
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Lack of diversification
Lack of liquidity
Excessive monitoring
Pursuing own goals at the expense of other
investors
Mechanisms (cont-d)
• Takeovers
– Ex-ante effect: managerial discipline
– Ex-post: efficient allocation of assets
• Value increasing takeovers should succeed
• Value decreasing takeovers should fail
– Failure of both goals may occur in reality
Mechanisms (cont-d)
• “Gatekeepers”
– Auditors
– Financial Analysts
– Credit Rating Agencies
• Should warn investors if things go wrong
• In reality sometimes fail
– Conflicts of interest
– Lack of incentives (lack of competition)
Mechanisms (cont-d)
• Minority shareholder actions
– Proxy Fights (vote for removal of current
management)
– Shareholder Activism (all kinds of pressure by a
shareholder (often an institution) on management:
shareholder proposals, “focus list” of poor performers,
articles in media, etc.)
– Shareholder litigation
• Overall, minority shareholder actions are rare
outside US and UK, empirically have rather
limited effect
• Russia: Hermitage case (see Dyck, Volchkova
and Zingales (2005))
Other mechanisms
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Adopting US GAAP, IFRS (IAS)
Hiring an independent auditor
Cross listing (listing abroad)
Sound dividend policy
…
We will consider Large Shareholders and
Takeovers in more detail now…