MGMT 165: Corporate Finance

Transcription

1 MGMT 165: Corporate Finance Corporate Governance Fanis Tsoulouhas UC Merced Fanis Tsoulouhas (UCM) Lectures 1 and 2 1 / 20

2 Moral Hazard The fundamental problem in corporate governance is a principal-agent problem between outsiders (investors, lenders) and insiders (executives, managers). Fanis Tsoulouhas (UCM) Lectures 1 and 2 2 / 20

3 Moral Hazard The fundamental problem in corporate governance is a principal-agent problem between outsiders (investors, lenders) and insiders (executives, managers). Insiders may not act in the best interests of the providers of funds. Fanis Tsoulouhas (UCM) Lectures 1 and 2 2 / 20

4 Moral Hazard The fundamental problem in corporate governance is a principal-agent problem between outsiders (investors, lenders) and insiders (executives, managers). Insiders may not act in the best interests of the providers of funds. Performance based incentive schemes and monitoring by current shareholders, future shareholders and debtholders can align the incentives of executives with those of investors. Fanis Tsoulouhas (UCM) Lectures 1 and 2 2 / 20

5 Moral Hazard The fundamental problem in corporate governance is a principal-agent problem between outsiders (investors, lenders) and insiders (executives, managers). Insiders may not act in the best interests of the providers of funds. Performance based incentive schemes and monitoring by current shareholders, future shareholders and debtholders can align the incentives of executives with those of investors. Corporate governance relates to the ways in which the providers of funds assure themselves of getting a return on their investment. Fanis Tsoulouhas (UCM) Lectures 1 and 2 2 / 20

6 Moral Hazard The fundamental problem in corporate governance is a principal-agent problem between outsiders (investors, lenders) and insiders (executives, managers). Insiders may not act in the best interests of the providers of funds. Performance based incentive schemes and monitoring by current shareholders, future shareholders and debtholders can align the incentives of executives with those of investors. Corporate governance relates to the ways in which the providers of funds assure themselves of getting a return on their investment. Good governance amounts to selecting the most able managers and making them accountable to investors. Fanis Tsoulouhas (UCM) Lectures 1 and 2 2 / 20

7 Moral hazard examples: Fanis Tsoulouhas (UCM) Lectures 1 and 2 3 / 20

8 Moral hazard examples: Insuffi cient effort Fanis Tsoulouhas (UCM) Lectures 1 and 2 3 / 20

9 Moral hazard examples: Insuffi cient effort Ineffi cient investments: extravagant investments (e.g. pet projects), insuffi cient investments in developing new products Fanis Tsoulouhas (UCM) Lectures 1 and 2 3 / 20

10 Moral hazard examples: Insuffi cient effort Ineffi cient investments: extravagant investments (e.g. pet projects), insuffi cient investments in developing new products Entrenchment: controlling the board of directors, promoting friends or loyal (to executives) employees, creative accounting, resisting hostile takeovers (for instance, by using "poison pills" excessively) or tender offers if they think they threaten their long-term positions Fanis Tsoulouhas (UCM) Lectures 1 and 2 3 / 20

11 Moral hazard examples: Insuffi cient effort Ineffi cient investments: extravagant investments (e.g. pet projects), insuffi cient investments in developing new products Entrenchment: controlling the board of directors, promoting friends or loyal (to executives) employees, creative accounting, resisting hostile takeovers (for instance, by using "poison pills" excessively) or tender offers if they think they threaten their long-term positions Private benefits: excessive perks (e.g. corporate jets, country club memberships, lavish resorts), insider trading Fanis Tsoulouhas (UCM) Lectures 1 and 2 3 / 20

12 Dysfunctional Governance Lack of transparency regarding compensation and perks (e.g. Jack Welch s retirement perks discovered only during his divorce proceedings). Fanis Tsoulouhas (UCM) Lectures 1 and 2 4 / 20

13 Dysfunctional Governance Lack of transparency regarding compensation and perks (e.g. Jack Welch s retirement perks discovered only during his divorce proceedings). Excessive executive compensation and perks. Fanis Tsoulouhas (UCM) Lectures 1 and 2 4 / 20

14 Dysfunctional Governance Lack of transparency regarding compensation and perks (e.g. Jack Welch s retirement perks discovered only during his divorce proceedings). Excessive executive compensation and perks. Weak link between performance and compensation (high compensation even with poor performance). Fanis Tsoulouhas (UCM) Lectures 1 and 2 4 / 20

15 Dysfunctional Governance Lack of transparency regarding compensation and perks (e.g. Jack Welch s retirement perks discovered only during his divorce proceedings). Excessive executive compensation and perks. Weak link between performance and compensation (high compensation even with poor performance). "Golden parachutes" Fanis Tsoulouhas (UCM) Lectures 1 and 2 4 / 20

16 Dysfunctional Governance Lack of transparency regarding compensation and perks (e.g. Jack Welch s retirement perks discovered only during his divorce proceedings). Excessive executive compensation and perks. Weak link between performance and compensation (high compensation even with poor performance). "Golden parachutes" Accounting manipulations (creative accounting) to inflate performance: Fanis Tsoulouhas (UCM) Lectures 1 and 2 4 / 20

17 Dysfunctional Governance Lack of transparency regarding compensation and perks (e.g. Jack Welch s retirement perks discovered only during his divorce proceedings). Excessive executive compensation and perks. Weak link between performance and compensation (high compensation even with poor performance). "Golden parachutes" Accounting manipulations (creative accounting) to inflate performance: Increase managerial compensation Fanis Tsoulouhas (UCM) Lectures 1 and 2 4 / 20

18 Dysfunctional Governance Lack of transparency regarding compensation and perks (e.g. Jack Welch s retirement perks discovered only during his divorce proceedings). Excessive executive compensation and perks. Weak link between performance and compensation (high compensation even with poor performance). "Golden parachutes" Accounting manipulations (creative accounting) to inflate performance: Increase managerial compensation Protect managers against turnover or takeovers Fanis Tsoulouhas (UCM) Lectures 1 and 2 4 / 20

19 Dysfunctional Governance Lack of transparency regarding compensation and perks (e.g. Jack Welch s retirement perks discovered only during his divorce proceedings). Excessive executive compensation and perks. Weak link between performance and compensation (high compensation even with poor performance). "Golden parachutes" Accounting manipulations (creative accounting) to inflate performance: Increase managerial compensation Protect managers against turnover or takeovers Reduce investor engagement Fanis Tsoulouhas (UCM) Lectures 1 and 2 4 / 20

20 Dysfunctional Governance Lack of transparency regarding compensation and perks (e.g. Jack Welch s retirement perks discovered only during his divorce proceedings). Excessive executive compensation and perks. Weak link between performance and compensation (high compensation even with poor performance). "Golden parachutes" Accounting manipulations (creative accounting) to inflate performance: Increase managerial compensation Protect managers against turnover or takeovers Reduce investor engagement Ensure that bank covenants are satisfied Fanis Tsoulouhas (UCM) Lectures 1 and 2 4 / 20

21 Managerial Incentives to Alleviate Moral Hazard Managers are provided with explicit incentives (managerial compensation). Fanis Tsoulouhas (UCM) Lectures 1 and 2 5 / 20

22 Managerial Incentives to Alleviate Moral Hazard Managers are provided with explicit incentives (managerial compensation). Managers are provided with implicit incentives (market career concerns). Fanis Tsoulouhas (UCM) Lectures 1 and 2 5 / 20

23 Managerial Incentives to Alleviate Moral Hazard Managers are provided with explicit incentives (managerial compensation). Managers are provided with implicit incentives (market career concerns). In addition, there is capital market monitoring by institutional investors (mutual funds, pension funds, banks), venture capitalists or large private investors. Fanis Tsoulouhas (UCM) Lectures 1 and 2 5 / 20

24 Managerial Incentives to Alleviate Moral Hazard Managers are provided with explicit incentives (managerial compensation). Managers are provided with implicit incentives (market career concerns). In addition, there is capital market monitoring by institutional investors (mutual funds, pension funds, banks), venture capitalists or large private investors. Product market competition also provides incentives. Fanis Tsoulouhas (UCM) Lectures 1 and 2 5 / 20

25 Monetary Incentives Managerial compensation takes the form of a fixed salary package (to ensure participation), and a bonus, stocks and stock options linked to performance (in order to provide incentives). Fanis Tsoulouhas (UCM) Lectures 1 and 2 6 / 20

26 Monetary Incentives Managerial compensation takes the form of a fixed salary package (to ensure participation), and a bonus, stocks and stock options linked to performance (in order to provide incentives). The bulk of the incentive component is the stock-based compensation, especially the stock options. Fanis Tsoulouhas (UCM) Lectures 1 and 2 6 / 20

27 Monetary Incentives Managerial compensation takes the form of a fixed salary package (to ensure participation), and a bonus, stocks and stock options linked to performance (in order to provide incentives). The bulk of the incentive component is the stock-based compensation, especially the stock options. Equity-based pay has increased dramatically in the last few decades. Fanis Tsoulouhas (UCM) Lectures 1 and 2 6 / 20

28 Monetary Incentives Managerial compensation takes the form of a fixed salary package (to ensure participation), and a bonus, stocks and stock options linked to performance (in order to provide incentives). The bulk of the incentive component is the stock-based compensation, especially the stock options. Equity-based pay has increased dramatically in the last few decades. The problem is that bonuses and equity-based pay incentives invite opportunism by manipulating accounting data and performance. Fanis Tsoulouhas (UCM) Lectures 1 and 2 6 / 20

29 Stocks vs Stock Options Stock options are call options which give you the right (but not the obligation) to purchase stock at pre-specified future dates at a given "exercise or strike price". These options are valuable only if the realized market price turns out to be above the strike price. Otherwise, the options are "out of the money" or "under water". Fanis Tsoulouhas (UCM) Lectures 1 and 2 7 / 20

30 Stocks vs Stock Options Stock options are call options which give you the right (but not the obligation) to purchase stock at pre-specified future dates at a given "exercise or strike price". These options are valuable only if the realized market price turns out to be above the strike price. Otherwise, the options are "out of the money" or "under water". Stock options yield managers a lower rent (the difference between market and strike price, rather than the full market price). Fanis Tsoulouhas (UCM) Lectures 1 and 2 7 / 20

31 Stocks vs Stock Options Stock options are call options which give you the right (but not the obligation) to purchase stock at pre-specified future dates at a given "exercise or strike price". These options are valuable only if the realized market price turns out to be above the strike price. Otherwise, the options are "out of the money" or "under water". Stock options yield managers a lower rent (the difference between market and strike price, rather than the full market price). Stock options provide stronger incentives than shares because granting shares provides managers with rent even for poor performance. Fanis Tsoulouhas (UCM) Lectures 1 and 2 7 / 20

32 Stocks vs Stock Options Stock options are call options which give you the right (but not the obligation) to purchase stock at pre-specified future dates at a given "exercise or strike price". These options are valuable only if the realized market price turns out to be above the strike price. Otherwise, the options are "out of the money" or "under water". Stock options yield managers a lower rent (the difference between market and strike price, rather than the full market price). Stock options provide stronger incentives than shares because granting shares provides managers with rent even for poor performance. Thus, stock options are more popular. Fanis Tsoulouhas (UCM) Lectures 1 and 2 7 / 20

33 Stocks vs Stock Options Stock options are call options which give you the right (but not the obligation) to purchase stock at pre-specified future dates at a given "exercise or strike price". These options are valuable only if the realized market price turns out to be above the strike price. Otherwise, the options are "out of the money" or "under water". Stock options yield managers a lower rent (the difference between market and strike price, rather than the full market price). Stock options provide stronger incentives than shares because granting shares provides managers with rent even for poor performance. Thus, stock options are more popular. The drawback of stock options is that if a manager expects them to be under water he may take excessive risks. The same "gambling for resurrection" problem occurs when a poorly performing manager fears losing his job. They also invite perverse incentives to mislead investors by backdating the options, in order to increase manager rents. Fanis Tsoulouhas (UCM) Lectures 1 and 2 7 / 20

34 Stocks vs Stock Options Stock options are call options which give you the right (but not the obligation) to purchase stock at pre-specified future dates at a given "exercise or strike price". These options are valuable only if the realized market price turns out to be above the strike price. Otherwise, the options are "out of the money" or "under water". Stock options yield managers a lower rent (the difference between market and strike price, rather than the full market price). Stock options provide stronger incentives than shares because granting shares provides managers with rent even for poor performance. Thus, stock options are more popular. The drawback of stock options is that if a manager expects them to be under water he may take excessive risks. The same "gambling for resurrection" problem occurs when a poorly performing manager fears losing his job. They also invite perverse incentives to mislead investors by backdating the options, in order to increase manager rents. Since 2005, stock options must be expensed. Fanis Tsoulouhas (UCM) Lectures 1 and 2 7 / 20

35 The long-term trend in executive compensation has been towards higher levels as well as towards stronger performance incentives, however, recent scandals enhance the concern about their perverse incentives. Fanis Tsoulouhas (UCM) Lectures 1 and 2 8 / 20

36 The long-term trend in executive compensation has been towards higher levels as well as towards stronger performance incentives, however, recent scandals enhance the concern about their perverse incentives. Strong incentives are also provided implicitly through the career concerns of managers, as well as the threat of dismissal (especially when the board is comprised mostly of outside directors or the company is in financial distress). Fanis Tsoulouhas (UCM) Lectures 1 and 2 8 / 20

37 Product Market Competition How well other competitors do in the product marketplace sets a yardstick against which the firm s management can be measured, making it more diffi cult for underperforming managers to attribute lackluster performance to unfavorable market conditions. Fanis Tsoulouhas (UCM) Lectures 1 and 2 9 / 20

38 Product Market Competition How well other competitors do in the product marketplace sets a yardstick against which the firm s management can be measured, making it more diffi cult for underperforming managers to attribute lackluster performance to unfavorable market conditions. Competition obviously makes it more diffi cult for a company to achieve high returns, partly because favorable market conditions (e.g., low input costs) may have uniform effects across the market firms, in addition to obvious price/quantity considerations. Fanis Tsoulouhas (UCM) Lectures 1 and 2 9 / 20

39 Product Market Competition How well other competitors do in the product marketplace sets a yardstick against which the firm s management can be measured, making it more diffi cult for underperforming managers to attribute lackluster performance to unfavorable market conditions. Competition obviously makes it more diffi cult for a company to achieve high returns, partly because favorable market conditions (e.g., low input costs) may have uniform effects across the market firms, in addition to obvious price/quantity considerations. Competition may also invite perverse effects, such as the "gambling for resurrection" mentioned earlier. Fanis Tsoulouhas (UCM) Lectures 1 and 2 9 / 20

40 Monitoring Monitoring by the board of directors, outside auditors, large shareholders, creditors, investment banks and rating agencies also disciplines management. Fanis Tsoulouhas (UCM) Lectures 1 and 2 10 / 20

41 Monitoring Monitoring by the board of directors, outside auditors, large shareholders, creditors, investment banks and rating agencies also disciplines management. Monitoring can be active or speculative. Fanis Tsoulouhas (UCM) Lectures 1 and 2 10 / 20

42 Monitoring Monitoring by the board of directors, outside auditors, large shareholders, creditors, investment banks and rating agencies also disciplines management. Monitoring can be active or speculative. An example of active monitoring is an institutional investor or a large shareholder introducing or threatening to introduce resolutions on corporate policy issues (for instance, response to takeovers, divesting noncore assets etc.) at general meetings of shareholders. Fanis Tsoulouhas (UCM) Lectures 1 and 2 10 / 20

43 Monitoring Monitoring by the board of directors, outside auditors, large shareholders, creditors, investment banks and rating agencies also disciplines management. Monitoring can be active or speculative. An example of active monitoring is an institutional investor or a large shareholder introducing or threatening to introduce resolutions on corporate policy issues (for instance, response to takeovers, divesting noncore assets etc.) at general meetings of shareholders. The typical speculative monitor is the stock market (or securities or financial) analyst working for an investment broker, bank etc. who studies management accomplishments in order to maximize portfolio return without any intend to intervene in the firm s management. Another type of speculative monitoring relates to (class-action) suits on behalf of shareholders or derivative suits on behalf of shareholders or creditors. Fanis Tsoulouhas (UCM) Lectures 1 and 2 10 / 20

44 The Board of Directors In general, the control of a company is divided between the board and the general meeting of shareholders. Fanis Tsoulouhas (UCM) Lectures 1 and 2 11 / 20

45 The Board of Directors In general, the control of a company is divided between the board and the general meeting of shareholders. The board of directors or executive board is a body of appointed persons who oversee the activities of a company. Fanis Tsoulouhas (UCM) Lectures 1 and 2 11 / 20

46 The Board of Directors In general, the control of a company is divided between the board and the general meeting of shareholders. The board of directors or executive board is a body of appointed persons who oversee the activities of a company. The company s bylaws specify the number of members of the board, how they are to be chosen and when they are to meet, as well as the powers, duties, and responsibilities delegated to them. Fanis Tsoulouhas (UCM) Lectures 1 and 2 11 / 20

47 The Board of Directors In general, the control of a company is divided between the board and the general meeting of shareholders. The board of directors or executive board is a body of appointed persons who oversee the activities of a company. The company s bylaws specify the number of members of the board, how they are to be chosen and when they are to meet, as well as the powers, duties, and responsibilities delegated to them. The board is elected by the shareholders and is the highest authority in the management of the corporation. Fanis Tsoulouhas (UCM) Lectures 1 and 2 11 / 20

48 Typical duties of the board include: Fanis Tsoulouhas (UCM) Lectures 1 and 2 12 / 20

49 Typical duties of the board include: Governing the organization by establishing broad policies, objectives and corporate strategy Fanis Tsoulouhas (UCM) Lectures 1 and 2 12 / 20

50 Typical duties of the board include: Governing the organization by establishing broad policies, objectives and corporate strategy Selecting, appointing, supporting and reviewing the performance of the CEO Fanis Tsoulouhas (UCM) Lectures 1 and 2 12 / 20

51 Typical duties of the board include: Governing the organization by establishing broad policies, objectives and corporate strategy Selecting, appointing, supporting and reviewing the performance of the CEO Determining executive compensation Fanis Tsoulouhas (UCM) Lectures 1 and 2 12 / 20

52 Typical duties of the board include: Governing the organization by establishing broad policies, objectives and corporate strategy Selecting, appointing, supporting and reviewing the performance of the CEO Determining executive compensation Ensuring the availability of adequate financial resources Fanis Tsoulouhas (UCM) Lectures 1 and 2 12 / 20

53 Typical duties of the board include: Governing the organization by establishing broad policies, objectives and corporate strategy Selecting, appointing, supporting and reviewing the performance of the CEO Determining executive compensation Ensuring the availability of adequate financial resources Approving annual budgets Fanis Tsoulouhas (UCM) Lectures 1 and 2 12 / 20

54 Typical duties of the board include: Governing the organization by establishing broad policies, objectives and corporate strategy Selecting, appointing, supporting and reviewing the performance of the CEO Determining executive compensation Ensuring the availability of adequate financial resources Approving annual budgets Accounting to the stakeholders (shareholders, debtholders) for the organization s performance Fanis Tsoulouhas (UCM) Lectures 1 and 2 12 / 20

55 Typical duties of the board include: Governing the organization by establishing broad policies, objectives and corporate strategy Selecting, appointing, supporting and reviewing the performance of the CEO Determining executive compensation Ensuring the availability of adequate financial resources Approving annual budgets Accounting to the stakeholders (shareholders, debtholders) for the organization s performance Offering advice and connections to management Fanis Tsoulouhas (UCM) Lectures 1 and 2 12 / 20

56 Typical duties of the board include: Governing the organization by establishing broad policies, objectives and corporate strategy Selecting, appointing, supporting and reviewing the performance of the CEO Determining executive compensation Ensuring the availability of adequate financial resources Approving annual budgets Accounting to the stakeholders (shareholders, debtholders) for the organization s performance Offering advice and connections to management Typically the board chooses one of its members to be the chair. Frequently, the CEO is also the chair of the board. Fanis Tsoulouhas (UCM) Lectures 1 and 2 12 / 20

57 Typical duties of the board include: Governing the organization by establishing broad policies, objectives and corporate strategy Selecting, appointing, supporting and reviewing the performance of the CEO Determining executive compensation Ensuring the availability of adequate financial resources Approving annual budgets Accounting to the stakeholders (shareholders, debtholders) for the organization s performance Offering advice and connections to management Typically the board chooses one of its members to be the chair. Frequently, the CEO is also the chair of the board. Boards operate through committees such as the management, compensation, nominating and audit committees. Fanis Tsoulouhas (UCM) Lectures 1 and 2 12 / 20

58 Typical duties of the board include: Governing the organization by establishing broad policies, objectives and corporate strategy Selecting, appointing, supporting and reviewing the performance of the CEO Determining executive compensation Ensuring the availability of adequate financial resources Approving annual budgets Accounting to the stakeholders (shareholders, debtholders) for the organization s performance Offering advice and connections to management Typically the board chooses one of its members to be the chair. Frequently, the CEO is also the chair of the board. Boards operate through committees such as the management, compensation, nominating and audit committees. The CEO (or managing director in the UK) is the head of the management committee. Fanis Tsoulouhas (UCM) Lectures 1 and 2 12 / 20

59 Problems affecting the effectiveness of boards include: Fanis Tsoulouhas (UCM) Lectures 1 and 2 13 / 20

60 Problems affecting the effectiveness of boards include: Lack of independence, especially when insiders sit on the board or when the board consists of friendly to the CEO directors or directors engaged in an ongoing relationship with management Fanis Tsoulouhas (UCM) Lectures 1 and 2 13 / 20

61 Problems affecting the effectiveness of boards include: Lack of independence, especially when insiders sit on the board or when the board consists of friendly to the CEO directors or directors engaged in an ongoing relationship with management Insuffi cient effort, especially when the directors are busy CEOs of other companies (which is often the case) Fanis Tsoulouhas (UCM) Lectures 1 and 2 13 / 20

62 Problems affecting the effectiveness of boards include: Lack of independence, especially when insiders sit on the board or when the board consists of friendly to the CEO directors or directors engaged in an ongoing relationship with management Insuffi cient effort, especially when the directors are busy CEOs of other companies (which is often the case) Insuffi cient incentives, especially because compensation consists for the most part of fees and perks (see Enron collapse) Fanis Tsoulouhas (UCM) Lectures 1 and 2 13 / 20

63 Problems affecting the effectiveness of boards include: Lack of independence, especially when insiders sit on the board or when the board consists of friendly to the CEO directors or directors engaged in an ongoing relationship with management Insuffi cient effort, especially when the directors are busy CEOs of other companies (which is often the case) Insuffi cient incentives, especially because compensation consists for the most part of fees and perks (see Enron collapse) The recent trend is towards more stock options Fanis Tsoulouhas (UCM) Lectures 1 and 2 13 / 20

64 Board Reform The Sarbanes-Oxley Act (SOX) of 2002 has introduced new standards of accountability on the board of directors for U.S. companies or companies listed on U.S. stock exchanges. Under the Act members of the board risk large fines and prison sentences in the case of accounting crimes. Internal control is now the direct responsibility of directors. This means that the vast majority of public companies now have hired internal auditors to ensure that the company adheres to the highest standards of internal controls. Additionally, these internal auditors are required by law to report directly to the audit board (Public Company Accounting Oversight Board). This group consists of board of directors members where more than half of the members are outside the company and one of those members outside the company is an accounting expert. Fanis Tsoulouhas (UCM) Lectures 1 and 2 14 / 20

65 Board Reform The Sarbanes-Oxley Act (SOX) of 2002 has introduced new standards of accountability on the board of directors for U.S. companies or companies listed on U.S. stock exchanges. Under the Act members of the board risk large fines and prison sentences in the case of accounting crimes. Internal control is now the direct responsibility of directors. This means that the vast majority of public companies now have hired internal auditors to ensure that the company adheres to the highest standards of internal controls. Additionally, these internal auditors are required by law to report directly to the audit board (Public Company Accounting Oversight Board). This group consists of board of directors members where more than half of the members are outside the company and one of those members outside the company is an accounting expert. There is a lot of current research on the implications of SOX. Fanis Tsoulouhas (UCM) Lectures 1 and 2 14 / 20

66 Investor Activism Corporate activists can initiate a proxy fight seeking to gain control of the board and/or removing management. Fanis Tsoulouhas (UCM) Lectures 1 and 2 15 / 20

67 Investor Activism Corporate activists can initiate a proxy fight seeking to gain control of the board and/or removing management. Corporate activists may attempt to persuade shareholders to use their proxy votes (i.e. votes by one individual or institution as the authorized representative of another). Fanis Tsoulouhas (UCM) Lectures 1 and 2 15 / 20

68 Investor Activism Corporate activists can initiate a proxy fight seeking to gain control of the board and/or removing management. Corporate activists may attempt to persuade shareholders to use their proxy votes (i.e. votes by one individual or institution as the authorized representative of another). Active monitoring requires control power. Fanis Tsoulouhas (UCM) Lectures 1 and 2 15 / 20

69 Investor Activism Corporate activists can initiate a proxy fight seeking to gain control of the board and/or removing management. Corporate activists may attempt to persuade shareholders to use their proxy votes (i.e. votes by one individual or institution as the authorized representative of another). Active monitoring requires control power. Control comes in two forms: formal and real (for instance, a VC in a start-up holds formal authority; by contrast, a block investor may hold real control by convincing other shareholders to create a dissenting majority. Fanis Tsoulouhas (UCM) Lectures 1 and 2 15 / 20

70 Share ownership patterns and, therefore, control differ between the US and the UK, where institutional investors (especially pension funds) are prominent, but the fraction of ownership is small and investors reshuffl e their portfolios frequently, versus other countries, where relationships are long-term (such as those in Japan, or in, say, Italy where most publicly listed firms are family owned). Fanis Tsoulouhas (UCM) Lectures 1 and 2 16 / 20

71 Share ownership patterns and, therefore, control differ between the US and the UK, where institutional investors (especially pension funds) are prominent, but the fraction of ownership is small and investors reshuffl e their portfolios frequently, versus other countries, where relationships are long-term (such as those in Japan, or in, say, Italy where most publicly listed firms are family owned). Monitoring by institutional investors may be impaired by the following facts: Fanis Tsoulouhas (UCM) Lectures 1 and 2 16 / 20

72 Share ownership patterns and, therefore, control differ between the US and the UK, where institutional investors (especially pension funds) are prominent, but the fraction of ownership is small and investors reshuffl e their portfolios frequently, versus other countries, where relationships are long-term (such as those in Japan, or in, say, Italy where most publicly listed firms are family owned). Monitoring by institutional investors may be impaired by the following facts: Pension or mutual funds typically hold less than 10% of the stock in order to avoid restrictions on short-term insider trading and receive favorable tax treatment Fanis Tsoulouhas (UCM) Lectures 1 and 2 16 / 20

73 Share ownership patterns and, therefore, control differ between the US and the UK, where institutional investors (especially pension funds) are prominent, but the fraction of ownership is small and investors reshuffl e their portfolios frequently, versus other countries, where relationships are long-term (such as those in Japan, or in, say, Italy where most publicly listed firms are family owned). Monitoring by institutional investors may be impaired by the following facts: Pension or mutual funds typically hold less than 10% of the stock in order to avoid restrictions on short-term insider trading and receive favorable tax treatment Such institutional investors are preoccupied with short-term profit Fanis Tsoulouhas (UCM) Lectures 1 and 2 16 / 20

74 Share ownership patterns and, therefore, control differ between the US and the UK, where institutional investors (especially pension funds) are prominent, but the fraction of ownership is small and investors reshuffl e their portfolios frequently, versus other countries, where relationships are long-term (such as those in Japan, or in, say, Italy where most publicly listed firms are family owned). Monitoring by institutional investors may be impaired by the following facts: Pension or mutual funds typically hold less than 10% of the stock in order to avoid restrictions on short-term insider trading and receive favorable tax treatment Such institutional investors are preoccupied with short-term profit Pension and mutual funds have a very dispersed set of shareholders and, therefore, face a similar moral hazard problem (who is monitoring the monitors?) Fanis Tsoulouhas (UCM) Lectures 1 and 2 16 / 20

75 Takeovers If traditional corporate governance fails because the board and the general assembly of shareholders are ineffective monitors, takeovers or the threat of takeovers may provide incentives to managers. Fanis Tsoulouhas (UCM) Lectures 1 and 2 17 / 20

76 Takeovers If traditional corporate governance fails because the board and the general assembly of shareholders are ineffective monitors, takeovers or the threat of takeovers may provide incentives to managers. Some of the drawbacks of takeovers are that they induce management to focus on short-term performance at the expense of long-term performance. Fanis Tsoulouhas (UCM) Lectures 1 and 2 17 / 20

77 Takeovers If traditional corporate governance fails because the board and the general assembly of shareholders are ineffective monitors, takeovers or the threat of takeovers may provide incentives to managers. Some of the drawbacks of takeovers are that they induce management to focus on short-term performance at the expense of long-term performance. Takeovers may also invalidate existing implicit agreements with other stakeholders. Fanis Tsoulouhas (UCM) Lectures 1 and 2 17 / 20

78 Takeovers If traditional corporate governance fails because the board and the general assembly of shareholders are ineffective monitors, takeovers or the threat of takeovers may provide incentives to managers. Some of the drawbacks of takeovers are that they induce management to focus on short-term performance at the expense of long-term performance. Takeovers may also invalidate existing implicit agreements with other stakeholders. Takeovers may be financed through leverage (i.e., by borrowing from a bank or by issuing bonds). Fanis Tsoulouhas (UCM) Lectures 1 and 2 17 / 20

79 Takeovers If traditional corporate governance fails because the board and the general assembly of shareholders are ineffective monitors, takeovers or the threat of takeovers may provide incentives to managers. Some of the drawbacks of takeovers are that they induce management to focus on short-term performance at the expense of long-term performance. Takeovers may also invalidate existing implicit agreements with other stakeholders. Takeovers may be financed through leverage (i.e., by borrowing from a bank or by issuing bonds). Acquisitions financed through debt are known as leveraged buyouts. Fanis Tsoulouhas (UCM) Lectures 1 and 2 17 / 20

80 Takeovers If traditional corporate governance fails because the board and the general assembly of shareholders are ineffective monitors, takeovers or the threat of takeovers may provide incentives to managers. Some of the drawbacks of takeovers are that they induce management to focus on short-term performance at the expense of long-term performance. Takeovers may also invalidate existing implicit agreements with other stakeholders. Takeovers may be financed through leverage (i.e., by borrowing from a bank or by issuing bonds). Acquisitions financed through debt are known as leveraged buyouts. Takeovers may be friendly or hostile. Fanis Tsoulouhas (UCM) Lectures 1 and 2 17 / 20

81 The bonds or other paper issued for leveraged buyouts are commonly considered not to be investment grade because of the significant risks involved. Many large buyouts in the 1980s produced insuffi cient cash flow to pay the interest of the borrowed capital, giving their bonds junk status (junk bonds). Fanis Tsoulouhas (UCM) Lectures 1 and 2 18 / 20

82 The bonds or other paper issued for leveraged buyouts are commonly considered not to be investment grade because of the significant risks involved. Many large buyouts in the 1980s produced insuffi cient cash flow to pay the interest of the borrowed capital, giving their bonds junk status (junk bonds). The volume of mergers and acquisitions in the 90s was substantially higher than in the 80s. Fanis Tsoulouhas (UCM) Lectures 1 and 2 18 / 20

83 The bonds or other paper issued for leveraged buyouts are commonly considered not to be investment grade because of the significant risks involved. Many large buyouts in the 1980s produced insuffi cient cash flow to pay the interest of the borrowed capital, giving their bonds junk status (junk bonds). The volume of mergers and acquisitions in the 90s was substantially higher than in the 80s. Many publicly traded firms were converted back to privately owned firms through leveraged buyouts, especially management buyouts. Fanis Tsoulouhas (UCM) Lectures 1 and 2 18 / 20

84 The bonds or other paper issued for leveraged buyouts are commonly considered not to be investment grade because of the significant risks involved. Many large buyouts in the 1980s produced insuffi cient cash flow to pay the interest of the borrowed capital, giving their bonds junk status (junk bonds). The volume of mergers and acquisitions in the 90s was substantially higher than in the 80s. Many publicly traded firms were converted back to privately owned firms through leveraged buyouts, especially management buyouts. A takeover is generally preceded by the purchase of a "toehold" (i.e., relatively small number of shares). Fanis Tsoulouhas (UCM) Lectures 1 and 2 18 / 20

85 The bonds or other paper issued for leveraged buyouts are commonly considered not to be investment grade because of the significant risks involved. Many large buyouts in the 1980s produced insuffi cient cash flow to pay the interest of the borrowed capital, giving their bonds junk status (junk bonds). The volume of mergers and acquisitions in the 90s was substantially higher than in the 80s. Many publicly traded firms were converted back to privately owned firms through leveraged buyouts, especially management buyouts. A takeover is generally preceded by the purchase of a "toehold" (i.e., relatively small number of shares). A takeover process may start with a tender offer. Fanis Tsoulouhas (UCM) Lectures 1 and 2 18 / 20

86 The bonds or other paper issued for leveraged buyouts are commonly considered not to be investment grade because of the significant risks involved. Many large buyouts in the 1980s produced insuffi cient cash flow to pay the interest of the borrowed capital, giving their bonds junk status (junk bonds). The volume of mergers and acquisitions in the 90s was substantially higher than in the 80s. Many publicly traded firms were converted back to privately owned firms through leveraged buyouts, especially management buyouts. A takeover is generally preceded by the purchase of a "toehold" (i.e., relatively small number of shares). A takeover process may start with a tender offer. Hostile takeovers took off in the 80s and peaked in the late 80s. Fanis Tsoulouhas (UCM) Lectures 1 and 2 18 / 20

87 Corporate charter defenses to takeover threats include: Fanis Tsoulouhas (UCM) Lectures 1 and 2 19 / 20

88 Corporate charter defenses to takeover threats include: Staggered boards (i.e., only a fraction of the board is up for re-election every year, so that it will take some time for a raider to gain full control) Fanis Tsoulouhas (UCM) Lectures 1 and 2 19 / 20

89 Corporate charter defenses to takeover threats include: Staggered boards (i.e., only a fraction of the board is up for re-election every year, so that it will take some time for a raider to gain full control) Supermajority rule (i.e., much more than 50%) needed to authorize certain significant changes Fanis Tsoulouhas (UCM) Lectures 1 and 2 19 / 20

90 Corporate charter defenses to takeover threats include: Staggered boards (i.e., only a fraction of the board is up for re-election every year, so that it will take some time for a raider to gain full control) Supermajority rule (i.e., much more than 50%) needed to authorize certain significant changes Differential voting rights provide privileged voting rights to shares that have been held for an extensive period Fanis Tsoulouhas (UCM) Lectures 1 and 2 19 / 20

91 Corporate charter defenses to takeover threats include: Staggered boards (i.e., only a fraction of the board is up for re-election every year, so that it will take some time for a raider to gain full control) Supermajority rule (i.e., much more than 50%) needed to authorize certain significant changes Differential voting rights provide privileged voting rights to shares that have been held for an extensive period Dual-class recapitalizations provide management or family owners with more votes than those granted by their shares Fanis Tsoulouhas (UCM) Lectures 1 and 2 19 / 20

92 Corporate charter defenses to takeover threats include: Staggered boards (i.e., only a fraction of the board is up for re-election every year, so that it will take some time for a raider to gain full control) Supermajority rule (i.e., much more than 50%) needed to authorize certain significant changes Differential voting rights provide privileged voting rights to shares that have been held for an extensive period Dual-class recapitalizations provide management or family owners with more votes than those granted by their shares Scorched-earth policies amount to selling assets, which the raider is keen on acquiring, at discounted prices Fanis Tsoulouhas (UCM) Lectures 1 and 2 19 / 20

93 Corporate charter defenses to takeover threats include: Staggered boards (i.e., only a fraction of the board is up for re-election every year, so that it will take some time for a raider to gain full control) Supermajority rule (i.e., much more than 50%) needed to authorize certain significant changes Differential voting rights provide privileged voting rights to shares that have been held for an extensive period Dual-class recapitalizations provide management or family owners with more votes than those granted by their shares Scorched-earth policies amount to selling assets, which the raider is keen on acquiring, at discounted prices Poison pills dilute the raider s equity (reduce the value of equity in the event of a takeover) by giving rights to existing shareholders to purchase additional shares at a discount or sell shares to the company at a premium Fanis Tsoulouhas (UCM) Lectures 1 and 2 19 / 20

94 Corporate charter defenses to takeover threats include: Staggered boards (i.e., only a fraction of the board is up for re-election every year, so that it will take some time for a raider to gain full control) Supermajority rule (i.e., much more than 50%) needed to authorize certain significant changes Differential voting rights provide privileged voting rights to shares that have been held for an extensive period Dual-class recapitalizations provide management or family owners with more votes than those granted by their shares Scorched-earth policies amount to selling assets, which the raider is keen on acquiring, at discounted prices Poison pills dilute the raider s equity (reduce the value of equity in the event of a takeover) by giving rights to existing shareholders to purchase additional shares at a discount or sell shares to the company at a premium Managers sometimes seek the help of a white knight (i.e., a friendlier to manager acquirer) Fanis Tsoulouhas (UCM) Lectures 1 and 2 19 / 20

95 Corporate charter defenses to takeover threats include: Staggered boards (i.e., only a fraction of the board is up for re-election every year, so that it will take some time for a raider to gain full control) Supermajority rule (i.e., much more than 50%) needed to authorize certain significant changes Differential voting rights provide privileged voting rights to shares that have been held for an extensive period Dual-class recapitalizations provide management or family owners with more votes than those granted by their shares Scorched-earth policies amount to selling assets, which the raider is keen on acquiring, at discounted prices Poison pills dilute the raider s equity (reduce the value of equity in the event of a takeover) by giving rights to existing shareholders to purchase additional shares at a discount or sell shares to the company at a premium Managers sometimes seek the help of a white knight (i.e., a friendlier to manager acquirer) Greenmail is the practice of repurchasing the raiders shares with company money by paying a premium (which may indicate collusion with the raider) Fanis Tsoulouhas (UCM) Lectures 1 and 2 19 / 20

96 Debt as an Incentive Mechanism Debt, especially of short-term maturity, can be an important incentive mechanism. Fanis Tsoulouhas (UCM) Lectures 1 and 2 20 / 20

97 Debt as an Incentive Mechanism Debt, especially of short-term maturity, can be an important incentive mechanism. Debt forces the company to give up cash upon repayment. Fanis Tsoulouhas (UCM) Lectures 1 and 2 20 / 20

98 Debt as an Incentive Mechanism Debt, especially of short-term maturity, can be an important incentive mechanism. Debt forces the company to give up cash upon repayment. Thus it reduces the temptation to unnecessarily spend or misappropriate "free cash flow". Fanis Tsoulouhas (UCM) Lectures 1 and 2 20 / 20

99 Debt as an Incentive Mechanism Debt, especially of short-term maturity, can be an important incentive mechanism. Debt forces the company to give up cash upon repayment. Thus it reduces the temptation to unnecessarily spend or misappropriate "free cash flow". Debt keeps managers inline to ensure that enough earnings and cash are generated in accord with the debt obligations. Fanis Tsoulouhas (UCM) Lectures 1 and 2 20 / 20

100 Debt as an Incentive Mechanism Debt, especially of short-term maturity, can be an important incentive mechanism. Debt forces the company to give up cash upon repayment. Thus it reduces the temptation to unnecessarily spend or misappropriate "free cash flow". Debt keeps managers inline to ensure that enough earnings and cash are generated in accord with the debt obligations. Under financial distress, the inability to repay debt yields control rights over to debtholders. Fanis Tsoulouhas (UCM) Lectures 1 and 2 20 / 20

101 Debt as an Incentive Mechanism Debt, especially of short-term maturity, can be an important incentive mechanism. Debt forces the company to give up cash upon repayment. Thus it reduces the temptation to unnecessarily spend or misappropriate "free cash flow". Debt keeps managers inline to ensure that enough earnings and cash are generated in accord with the debt obligations. Under financial distress, the inability to repay debt yields control rights over to debtholders. Pleading bankruptcy can lead to loss of employment and stigma. Fanis Tsoulouhas (UCM) Lectures 1 and 2 20 / 20