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Reading: The Theory of Corporate Finance by Jean Tirole (Princeton University Press), Chapter 1
CorporateGovernance(excludingsection1.10)
Introduction
Aneconomicsbasetothescholar
1970sArrowDebreugeneralequilibriummodeloffrictionlessmarkets
Presumedperfectlycompetitiveandcomplete,andunhamperedbytaxes,transactioncosts,and
informationalasymmetries)
Butsaidlittleaboutfirm'sfinancialchoicesandtheirgovernance.Moralhazardruledout.
Financialmarketsassumedtobenotplaguedbyinformationasymmetry.
KeyIssueAllocationofriskamonginvestorsandpricingofredundantclaimsbyarbitrage.
1958,1963TwoMMpapers.
FirmsfinancialstructureisirrelevantinsomeconditionsorintheArrowDebreuenvironment.
Thesizeofthepieisunaffectedbythewayitiscarved.
Sincethe1980s
Principaldirectionofinquiryhasbeentointroduceagencyproblemsatvariouslevelsofthe
corporatestructure.(Managerialteam,specificclaimholders)
Attentiontoagencyconsiderationsincorporatefinancereceivedconsiderablesupportfrom
largeempiricalliteratureandfromthepracticeofinstitutionaldesign.
Ch1andCh2
Aimatprovidinganoverviewofthekeyinstitutionalfeatures,empiricalregularitiesandpolicy
issuesthatwillmotivateandguidethesubsequenttheoreticalanalysis.
Divisionoftheoreticalliteratureonmicroeconomicsofcorporatefinanceinbranches:
1. Focusesonincentivesofthefirm'sinsiders.FinancialContractingThedesignofanincentive
schemefortheinsidersthatbestalignstheinterestofthetwoparties
2. Addressesbothinsider'sandoutsider'sincentivesbytakingalesspassiveviewoftheroleof
outsiders.Subdividedinto:
a. Monitoringofmanagementbyoneorseveralsecurityholders
3. Takesintoaccounttheexistenceofinvestor'sclientelesandtherebyreturnstotheviewthat
securityholdersdifferintheirpreferencesforstatecontingentreturns.
Whiletherehavebeentremendousnumberofcontributionsonthetheoreticalfront,thereisstilllack
ofunifiedframeworkthatdisheartensstudentsofcorporatefinance.Widediscrepancyofassumptions
acrosspapersnotonlylengthensthelearningprocessbutalsomakesitdifficultforoutsiderstoidentify
thekeyeconomicelementsdrivingtheanalyses.
Chapter1:
1932,AdolfBerleandGardinerMeans:Documenttheseparationofownershipandcontrolin
theUS
Managerialdiscretioncreatedbyshareholderdispersioncanbeabused;theyareunwatched
Corporateinsidersneednotactinthebestinterestsoftheprovidersoffunds
Synopsis:
Thereadingbeingthefirstchapterhasbeenwrittenasaguidetothecompletebookwheretheauthor
brieflyintroducesvariousconceptsdealtinthebookandthegivesafairideaofthedepthofthetopicby
efficientlyinterweavingcontemporaryexampleswiththeresearchfindings.Theprimaryobjectiveof
the chapter is to explain and address the larger issue of corporate governance. The text can be aptly
labelledasasummaryoftheresearchadvancesintheareaaswellastheongoingscholarlydebates.
TheDiscussion:
Thediscussionshallbeginwiththeconceptofseparationofownershipandcontrolinacorporatebody.
The basic concern being the abuse of managerial discretion created by shareholder dispersion can be
abused.Sincemanagersareunwatched,theymaynotactinthebestinterestsoftheprovidersoffunds.
The following burning issues at hand would be the core of the discussion: Transparency, Managerial
Accountability,CorporateGovernanceFailures,WeakBoardofDirectors,HostileTakeovers,Protection
ofminorityshareholders,InvestorActivism
Theinitialsection1.11.2emphasizetheimportanceofmanagerialaccountability.Therewouldbeeffort
towards evaluating the definition of corporate governance and its scope. We shall discuss the various
forms in which dysfunctional governance can take place and the illintended efforts that toplevel
executivesputintocoverupovertheirinefficienciesorvestedinterests.Thereafter,theauthorreviews
variousinstrumentsandfactorsthathelpalignmanagerialincentiveswiththoseofthefirm:monetary
compensation,implicitincentives,monitoring,andproductmarketcompetition.
Insection1.31.6,thetextgoesintoadeepanalysisoftheconceptofmonitoring.Weshalldelveintothe
variousformsofmonitoringandtheirintricacies.Thediscussionshallmajorlyinvolvethevariousbodies,
bothinsideandoutsidethefirm,andmechanismswhichhelpinkeepinganeyeontheinsiders.Fromthe
boardsofdirectors,largeshareholders,raiders,andbankstodebtasamechanismwillbediscussedto
understandtheroles,responsibilitiesandrelatedregulations.Also,amajorpartofthediscussionwould
involvethelimitationsfacedbyeachofthebodies.
Section1.7discussesthedifferencesincorporategovernancesystems.Thediscussionwouldinvolvethe
followingbasisfordrawingoutrelevantdifferences:Commonlaw,Civillaw,shareholderprotectionand
creditorprotection.
Intheend,discussionwouldbeconcludedovertheobjectiveofthefirm,namely,whommanagers
shouldbeaccountableto,andthelongstandingdebatebetweentheproponentsofthestakeholder
societyandthoseofshareholdervaluemaximization.
1.1
TheAgencyproblem:StrongManagersandDispersedShareholders
1990s:CommitteesandcodesforbestpracticeforBoardsstartedcomingin
CorporateGovernancedefinition:
o Waysinwhichthesuppliersoffinancetocorporationsassurethemselvesofgettinga
returnontheirinvestment[ShleiferandVishnys(1997)andBechtetal.(2002)]
o toonarrowasadefinitionwithonlyfocusoninvestor'sreturns;stakeholdersignored
o Booksubscribestothenarrowview
1.1.1
Fourcategoriesofmoralhazard:
A. InsufficientEffort
Theissueisnotthenumberofhoursspentintheofficebuttheallocationofworktime
tovarioustasks
InconvenienceandUnpleasantnessin:
i. Switchingtoalesscostlysupplier
ii. Reallocatingtheworkforce
iii. Takingatougherstanceinwagenegotiations
Insufficientefforttotheoversightofsubordinates(Internalcontrol)
Overcommitmenttocompetitiveactions:politicalinvolvement,investmentsinother
ventures,andmoregenerallyactivitiesnotorlittlerelatedtomanagingthefirm
B. ExtravagantInvestments
Engagementinpetprojectsandempirebuildingtothedetrimentofshareholders
Firmsearningwindfallcashawardsincourtdonotreturnthecashtoinvestorsand
spenditinefficiently
C. EntrenchmentStrategies
Oftenexecutivestakeactionsthathurtshareholderstokeeptheirpositionsecure
Investinactivitiesthatmakethemindispensable(ShleiferandVishny,1989)
Manipulateperformancemeasuressoastolookgoodwhentheirpositionmightbe
threatened.E.g.creativeaccountingtechniques,excessiveorinsufficient
Actingexcessivelyconservativewhentheirperformanceissatisfactory,takingexcessive
riskandthusgambleforresurrection
Managersroutinelyresisthostiletakeovers,asthesethreatentheirlongtermpositions.
E.g.defeatingattractivetenderofferstoshareholders,findinga"whiteknight",
concludinganonaggressionpactwiththeraider,limitingshareholderactivism
D. SelfDealing
Managersmayconsumeperks;Pickingtheirsuccessor,whowouldn'tcriticizeorcast
shadowontheirpastmanagement;Contractingonfriendshipandkinshipgrounds;
Financingpoliticalparties
Engaginginillegalactivitiesandinsidertrading
Moralhazardalleviationscantaketworoutes:
Insider'sincentivesmaybepartlyalignedwithinvestor'sinterests:Performancebased
incentives
InsidersaremonitoredviaBoard,potentialshareholders,debtholders
1.1.2
"Tipoftheiceberg"Managerialmisbehavior,submergedpartinstitutionalresponseandmanagerial
incentivecontracts
FormsofDysfunctionalGovernance:
A. LackofTransparency
Imperfectlyinformedoutsidepartiesabouttopmanagementcompensations;limited
transparencyofmanagerialstock;perksareunknowntoinvestors;recruitingfamilyand
friendsforimportantpositions
B. Level
Substantialincreaseintotalcompensationpackages;
Proponentsofhighlevelcompensationpointtowardsperformancebasedpay
C. Thinlinkbetweenperformanceandcompensation.Reasons:
Poorlystructuredpackages
Managersseentomanagetomaintaintheircompensationstableorevenhaveit
increaseddespitepoorperformance
Gettingoutontime
Largegoldenparachutes
D. AccountingManipulations
Legalandillegalmanipulationstoinflatecompanyperformance.Purposesserved:
i. Increasetheapparentearningsand/orstockprice
ii. Protectmanagersagainstdismissalsortakeoversorreduceinvestor
interference
iii. Nottoviolatebankcovenantsandenablecontinuedfinancing
1.2.1
Bonusesandstockoptionsmakemanagerssensitivetolossesinprofitandinshareholdervalue.Implicit
incentives,fearofbeingfiredandfutureprospectskeepmanagersontheirtoes.
1.2.2
Thecompensationpackage:Salary+Bonus+Stockbasedincentives.Dramaticincreaseinstock
options.
"someloopholesthatallowmanagerstoundosomeoftheirexposuretothefirmsprofitability
throughlessstrictlyregulatedfinancialinstruments,suchasequityswapsandcollars"
Bonusesandshareholdings:substitutesorcomplements?
bonusesandstockoptionsservetwodifferentandcomplementarypurposes;bonuses
createsshorttermincentivewhilestockbasedincentivesencouragemanagementto
takealongtermperspective
Thecompensationbase
compensationshouldbebasedonfactorsthatarenotoutsidethecontrolofthe
manager;indexingcompensationtotherelevantvariables;itmustalsobeunaffectedby
therealizationofexogenousshocks
Relativeperformanceevaluation
CEOsareconsequentlyrewardedforluck
Shouldmanagersberewardedthroughstraightsharesorthroughstockoptions?
Executivecompensationcontroversy
Upwardtrendandemphasisonperformancelinkedpackages
JensenandMurphyarguethatCEOincentivesnottowasteshareholdervaluearetoo
small.
1.2.3
ImplicitIncentives
Riskoflosingpositiononpoorperformance
Increasedmonitoring
ThereisafairamountofevidencethatexecutiveturnoverintheUnitedStatesiscorrelatedwith
poorperformance,usingeitherstockoraccountingdata
Areexplicitandimplicitincentivescomplementsorsubstitutes?
1.2.4
Monitoring
Activemonitoring:forwardlooking,exerciseofcontrolrights
largeshareholder,institutionalinvestor,raider,creditors
Speculativemonitoring:backwardlooking,
toadjusthispositioninthefirm,legalsuitsbyshareholders
Largenumberofothereyeballs:besidesstockanalysts,ratingagencies,auditors
Conflictofinterest
1.2.5
ProductMarketCompetition
firmscompetitiveenvironment
closecompetitorsofferayardstick
tendstofilteroutorattenuatetheexogenousshocksfacedbythefirm
alsocreatesperverseeffects
competitioncanneversubstituteforgovernance
1.3
TheBoardofDirectorsmonitorsmanagementonbehalfofshareholders
1.3.1
BoardsofDirectors:WatchdogsorLapdogs?
Lackofindependence
Aboutexecutivechairmanship
Insufficientincentives
Shareholderlawsuits
Avoidanceofconflict
1.3.2
ReformingtheBoard
Teammatesorreferees?
Knowledgeversusindependence?
Whatcanlinkfromperformancetoboardcompensation?
CalPERSList
1.4
InvestorActivism
1.4.1
InvestorActivismComesinManyGuises
Activemonitoringrequirescontrol:MajorityandMinority
Proxyfights.
Astockholderoragroupofstockholdersunhappywithmanagerialpoliciesseekseitherelectiontothe
boardofdirectorswiththeultimategoalofremovingmanagement,orsupportbyamajorityof
shareholdersforaresolutiononaspecificcorporatepolicy.
1.4.2
PatternofOwnership
Ownershipconcentration
Crossshareholdings
Stableholdingsversusactiveportfoliomanagement
1.4.3
TheLimitsofActiveMonitoring
Whomonitorsthemonitor?
Institutionalmoneymanagers
Congruencewithotherinvestors
Undermonitoring
Collusionwithmanagement
Selfdealing
Costofprovidingproperincentivestothemonitor
Perverseeffectsonthemonitorees
Legal,fiscal,andregulatoryobstacles
1.5
TakeoversandLeveragedBuyouts
perceivedwithawe,horror,andadmiration
representtheworstofanAmericancapitalismbasedongreedandmyopia
originalmodeofcorporategovernancethatsubstitutesefficientteamsforentrenched,money
wastingmanagers
1.5.1
TakeoverBidsandDefenses
Theideabeingthatthebidderisofteninterestedinthesharesonlyifheobtainsacontrollingstake
Defenses
Corporatecharterdefenses
Supermajorityrule
Fairpriceclauses
Differentialvotingrights
Movetoastatewithtougherantitakeoverstatutes
Scorchedearthpolicies
Enteringlitigation
Poisonpills
Whiteknight
Greenmail
1.5.2
LeveragedBuyouts
Takingafirmprivatebypurchasingitssharesandallocatingthemtoaconcentratedownership
composedofmanagement,ageneralpartner,andotherinvestors
Concerningleverage,LBOtargetshavetogeneratelargeandsteadycashflowsinordertoservicethe
highdebtpayments
1.5.3
TheRiseofTakeoversandtheBacklash:WhatHappened?
Hypothesis1:Declineofcorporategovernance
Hypothesis2:Financialinnovation
Hypothesis3:Breakupofconglomerates
1.6
DebtasaGovernanceMechanism
1.6.1
DebtasanIncentiveMechanism
preventsmanagersfromconsumingcash
incentivizesthecompanysexecutivesforservicingdebt
threatofilliquidityhasapositivediscipliningeffect
intheabsenceofliquidation,thenonrepaymentofdebtputsthecreditorsinthedriversseat
managersholdasubstantialamountofclaimsoverthefirmscashflow,debtholdingby
investorshasbenefits
1.6.2
LimitstoDebtasaGovernanceMechanism
Costofilliquidity
Bankruptcycosts
Transactioncosts
Bargaininginefficiencies
1.7
InternationalComparisonsofthePolicyEnvironment
Commonlaw:Englishspeakingcountries,emphasizesjudiciaryindependence,reactivityto
precedents,andlimitedcodification
Civillaw,incontrast,stressescodification
Protectionofshareholdersisstrongestincommonlawcountries,weakestinFrenchstylecivil
lawcountries
LaPortaetal.(1997)Apositivecovariationbetweenshareholderprotectionandthebreadthof
theequitymarket
1.8
ShareholderValueorStakeholderSociety?
Awidespreadviewinpoliticsandpublicopinionisthatcorporationsshouldservealargersocialpurpose
andberesponsible,thatis,theyshouldreachouttootherstakeholdersandnotonlytoshareholders.
1.8.1
TheCorporateSocialResponsibilityView
Dutiestowardemployees
Dutiestowardcommunities
Dutiestowardcreditors
Ethicalconsiderations
Thepopularityofthestakeholdersocietyviewinthepublicistobecontrastedwiththestrong
consensusamongfinancialeconomiststhatmaximizingshareholdervaluehasmajoradvantagesover
thepursuitofalternativegoals.
1.8.2
WhattheStakeholderSocietyIsandWhatItIsNot
recommendationistotreatemployeesfairlythroughjobsecurity,trainingfacilities,etc.Thereasoningis
that,bybuildingareputationforfairness,thefirmwillbeabletoattractthemosttalentedemployees
andtoinducethemtoinvestinthefirm,astheemployeeswillknowthattheyareengagedinalong
termrelationshipwiththefirmandthattheirfirmspecificinvestmentswillberewarded.
whydoesoneneedalawinthefirstplace?
1.8.3
ObjectionstotheStakeholderSociety
givingcontrolrightstononinvestorsmaydiscouragefinancinginthefirstplace
Theissuewiththesharingofcontrolbetweeninvestorsandnaturalstakeholdersisnotonlythat
itgenerateslesspledgeableincomeandthereforelessfinancingthaninvestorcontrol,butalso
thatitmaycreateinefficienciesindecisionmaking.
theconceptofstakeholdersocietyismanagerialaccountability