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Session3:DiscussionNote

Reading: The Theory of Corporate Finance by Jean Tirole (Princeton University Press), Chapter 10
ControlRightsandCorporateGovernance(Section10.310.5)

10.3CorporateGovernanceandRealControl

Oftenplayerswithoutformalcontrolrightsactuallyenjoysubstantialcontrolovertheir
organizations.(AghionandTirole,1997)
Twostandardexamples:
Boardsofdirectorsoftenrubberstampthetopmanagementsdecisions
Largeminorityshareholdersoftendecideforthemajoritygroupofsmallerones.
Allocationofformalcontrolthuscannotbethefullstory:thereisseparationbetween
ownershipandcontrol

DistinctionbetweenFormalControlandRealControl

Manyassumethatmanagementhasformalrightsonmanyissues.Factually,managementneeds
torefertohigherauthoritiesforpermission.
Managersenjoymuchpower,though,inpartbecausetheyhaveproprietaryinformationthat
oftenenablesthemtogettheirway.
Shareholdershaveformalcontroloveranumberofdecisions,managersoftenhaverealcontrol.

TwoQuestionsaboutallocation:

Whymustmanagementdefertoshareholdersforsomedecisions,butnotothers?
Howistheallocationofcontrolrightsinfluencedbythefirmsbalancesheet?

Whenformalcontrolisgiventoinvestors,asisthecaseformanykeydecisions,theextentofactual
controlenjoyedbymanagementisafunctionofthepresenceandincentivesofactivemonitors,ofthe
divergenceofobjectivesamonginvestors,andsoforth.

10.3.1Heuristics
Wediscusstheextentofrealcontrolbymanagement.

Investorswillrubberstamptheentrepreneur'sproposalifandonlyif
E(|Rb>=0)>=0
i.e.thekeytomanagerialrealcontroliscongruence

Higherthepowerofthemanagerialincentivescheme,themorelikelyitisthatinvestorswillgo
alongwiththeentrepreneursproposal

Twounderstandings:

Afirmwithastrongbalancesheet(ahighA)mustpaybacklesstoinvestors;thusRbislargeand
sotheentrepreneurenjoysmuchrealcontroloverdecisions.
Conversely,afirmwithaweakbalancesheet(alowA)hasalowRbandthereforealow
congruencebetweentheentrepreneurandinvestors.Thiswillresultinfrequentdeadlocks.

Whendeadlocksarefrequent,anactivemonitorwhocanbringfurtherinformationtobearonthe
decision,maybreakdeadlocksandthereforebeparticularlyhelpful,asarguedbyBurkartetal.(1997)
(who,citingFranksetal.(1996),notethatownershipconcentrationintheUnitedKingdomincreases
duringperiodsoffinancialdifficulty).
Combinedwiththeinformationconveyedbythefactthattheentrepreneurrecommendsmovingaway
fromthestatusquo,itallowsinvestorstomakeabetterinformeddecision.
Existenceofsuchamonitoristermedas"relationshiplending"andabsenceofamonitorisreferredas
an"arm'slengthrelationship"
Whenthemonitordoesnothaveamajorityofvotingsharesandhasaconflictofinterestwiththeother
investors,theotherinvestorsshouldassesstheirrelativecongruencewiththeentrepreneurandthe
monitorforthetypeofdecisionatstake.

10.3.2StrengthoftheBalanceSheetandCorporateGovernance

Isafirmwithastrongbalancesheetmoreorlesslikelytoresorttorelationshiplending?

DeterminantsofTrustandMonitoring

Tworesults:
o Astrongerbalancesheetleadstoalessconflictualrelationshipwith(morerubber
stampingby)armslengthlenders.
o Relationshiplendingisassociatedwithaweakbalancesheet.

ArmsLengthRelationship
Rubberstampingcannothurtinvestorswhoalwayshavetheoptionnottogoalongwiththe
entrepreneursrecommendation;anditalwaysbenefitstheentrepreneur,whomakesa
recommendationonlyifitsacceptancebenefitsher.Becauserubberstampingrequiresmutualconsent,
theactioncanonlyincreasevalueinexpectation,ifnotnecessarilyineachofitsrealizations.
Thepledgeableincomeneednotbeamonotonicfunctionofentrepreneurialcompensation.
Iftwostakesleadtothesameexpectedinvestorincome,thehigherofthetwomakestheentrepreneur
betteroffbothbecauseitdirectlyyieldshermoreincomeinthecaseofsuccessandbecauseitgivesher
morerealauthority.

RelationshipLending
Twobenefits:

Atightrelationshipwithalargeinvestorreducesmoralhazardandmaybetheonlywayforthe
firmtoharnesssufficientpledgeableincomeandtherebysecurefinancing.
Facilitatesdecisionmakinginasituationinwhichinvestorsaresuspiciousoftheborrowers
motivation.

ApplicationtoDisclosure
Theentrepreneurwillhavetosupplymoreinformationtoinvestorsasthebalancesheetdeteriorates
andthisdeteriorationisobservedbyinvestors(anunobserveddegradationbydefinitiondoesnotraise
concernswithinvestors).
Disclosuremaybeformalizedintwoways:anoverallexantedisclosurepolicyandanexpost
spontaneousdisclosure,whereexpostreferstoasituationinwhichtheentrepreneuralreadyknows
theproposalscharacteristics(,).
Adoptingadisclosurepolicyisequivalenttogoingforrelationshiplending,ratherthankeepinganarms
lengthrelationship.Wecanthusconcludethatfirmsthatneedtoraisefundsorrenegotiateexisting
loanswillengageinmoredisclosurewhenhavingan(observably)weakerbalancesheet.Putdifferently,
firmswilldisclosemoreinbadtimesthaningoodtimes.
ManagerialInitiative
Assumingthatideasforanewcourseofactiondonotariseexogenously;rather,theyrequire
entrepreneurialinitiative.
Result:Entrepreneurialinitiativedecreaseswiththeownershipshareofthemonitorwhenthe
entrepreneurhasrealauthorityintheabsenceofmonitoring.
Intuitionfortheresult:anincreaseinthemonitorsshareenhancesthelattersincentivetoacquire
informationabouttheprofitabilityoftheentrepreneursproposal.
Iftheentrepreneurenjoysrealauthorityintheabsenceofmonitoring,theresultingincreaseinthe
intensityofmonitoringresultsinahigherlikelihoodthattheproposalbeoverturnedormodifiedand
thusinalowerpayoffassociatedwithcomingupwithproposalsinthefirstplace.
Iftheentrepreneurdoesnotenjoyrealauthorityintheabsenceofmonitoring(hersuggestionsare
rejected),thenmonitoringnecessarilyenhancesinitiative,becausemonitoringcreatesatleastsome
probabilitythatasuggestionbeaccepted.

10.3.3PrivateBenefitsofLargeShareholders
Largeblockssellatapremiumrelativetothemarketpriceofindividualshares,aswasshownbyBarclay
andHolderness(1989)forblocksofatleast5%ofcommonstockslistedontheNewYorkStock
ExchangeortheAmericanStockExchange.

Reasonswhyablocksharemaybevaluableinfirmswithoutamajorityshareholder:

Whenshareholdersinterestsdiverge,coalitionsmustbeformedinorderfortheboardtomake
adecision.Alargeblockholdermaybeuniquelyplacedtobepartofthiscoalitionandmay
derivesomebenefits,e.g.,acashtransferoranincreaseinownershipstake,intheformationof
amajoritycoalition(Zwiebel1995)
Second,theremaybeaseriousfailureofcorporategovernance.
Third,thelargeshareholdermayenjoycontrolamenities(prestigeandperksattachedto
sittingontheboard,etc.)

Evenwhencorporategovernancefunctionsproperly,thelargeblockholdermayenjoyrealauthority,in
thesamewaythatthemanagerenjoysrealauthority.Asthelargeblockholderwillhaveahigherimpact
ondecisionmakingifhisinterestsarebetteralignedwiththoseofmajorityshareholders.

10.4AllocationofControlRightsamongSecurityholders

10.4.1PotentialRationalesfortheMultiplicityofSecurities
Thedivergenceofobjectivescreatesexternalities.Forexample,itiswellknownthatshareholdersmay
wanttoselectnegativeNPVactionsthatincreaseriskandexpropriatedebtholders,andthatcostly
covenantsandexitoptionsprotectingdebtholders(shorttermdebt,convertibledebt)mustbeputin
placesoastolimittheimportanceofthisphenomenon(JensenandMeckling1976).
Explainingthecoexistenceofmultiplesecuritieswithdifferentiatedcontrolrightsisoneofthemain
challengescurrentlyfacingcorporatefinancetheory.

10.4.1.1InvestorsDemandforSpecificSecurities
Investorsdonothaveidenticalpreferencesastothecharacteristicsofsecurities.Theymayforexample
facedifferenttaxtreatmentsormarginalrates,orhavedifferentliquidityneeds.
Unlikelongterminvestors,shortterminvestorsareconcernedaboutlosingmoneytobetterinformed
tradersinthemarketwhentheyreselltheirassets(asinKyle(1985)forexample).Theywillthusbe
eagertobuylowinformationintensitysecurities
Issuestocksforlongterminvestorsandbondsforthosewithmorepressingliquidityneeds.
Itisunclearwhethersecuritydesignandrepackagingfortheclientelesbenefitshouldbeperformedat
thefirmsleveloratthatofanintermediary.
Adifferentissuerelatedtotheexistenceofintermediariesiswhethertheycouldnotbundlehigh
informationintensityassetsfromdifferentfirmsinordertocreatethelowinformationintensity
securitiesdesiredbyshortterminvestors?

10.4.1.2LiquidityManagement
Anotherimportantdimensionofsecuritydesignisthetimingofthefirmsliquidityneeds.

StartUpv/safirminamatureindustry
Differentsecuritieshavedifferentimpactsonthefirmsavailableliquidity.

Thefirmcouldequivalentlyreplacethisarrayofsecurities(shorttermdebt,equity,etc.)withdifferent
cashdrainingcharacteristicsbyasingle,compositeonewhichwouldhavethesametimingandamount
ofliquiditydemandsonthefirm.

10.4.1.3Monitoring
Another,relativelyunexplored,approachtoexplainingthemultiplicityofclaimswouldfocusonthe
multidimensionalnatureofmonitoring,togetherwithaconflictofinterestbetweenthevarious
monitoringtasks.
Monitoringoffirstorderstochasticdominance(profitenhancement)usuallyrequirescompensatingthe
monitorwithaclaimonprofitthatputsheavyweightontheupside.Suchclaims,however,may
discouragethemonitorfrompayingattentiontorisktaking.
Tosumup,multitaskmonitoringmaygiverisetothecreationofconflictingclaimsfordifferentactive
monitors;yet,perse,itwillnotexplainthemultiplicityofclaimsofferedtouninformedinvestors(e.g.,
corporatebondsandequitiesheldbysmallinvestors).

10.4.1.4ControlRights:MultipleSecuritiesasaDiscipliningDevice
Thereturnstructureofaclaimdeterminesitsholdersmonitoringfocusonsomeaspectsof
managementaswellastheintensityofmonitoring.
Thereturnalsodeterminestheholderschoiceofinterventionifcontrolrightsarebundledwiththe
returnstream.Thussecuritydesignalsomattersfromacontrolrightsperspective.

10.4.2SecurityDesignasaDiscipliningDevice
AghionBoltonmodeldoesnotexplainthecoexistenceofmultipleclaims(e.g.,debtandequity)with
differentcontrolrights.
Control,however,isoftenexertedbyinvestorswhoseclaimmakesthemunrepresentativeofthe
communityofinvestorsasawhole.
Whydocertaincontrolrightsgotocertaincashflowclaims?
Thecarrotandstickviewofsecuritydesignemphasizesthecontingentallocationofcontrolamong
outsiders.

Thecarrotandthestickareprovidedbyallocationsofcontroltoinvestorswhoaremoreorless
congruentwithmanagement.
Allocatingcontroltotoughinvestorsnamely,investorswhosepreferences(asimpliedbytheircash
flowclaim)havelittlecongruencewiththoseofmanagerswheninterimmanagerialperformanceis
weakandtosoftinvestorsnamely,investorswhosepreferencesarelessdissonantwiththoseof
managementwheninterimmanagerialperformanceissatisfactorycreatesgoodincentivesfor
management.
Implications:
Differentcoursesofactionhavedifferentimpactsontheentrepreneurswelfare.Thisassumption
impliesthattheentrepreneurisnotindifferentastowhowillreceivecontrolrights,andhencethata
contingentallocationofcontrolrightscanbeusedtodisciplinetheentrepreneur.
Thisfirstassumptiondeliversatheoryofsecuritydesigninwhichcontingentcontrolrightscovarywith
cashflowrights.
Thespecificsecuritydesign,namely,theallocationofcontroltoequityholdersinnormaltimesandto
debtholdersinbadtimes,isthatthecourseofactionleastpreferredbytheentrepreneur(whichwe
labeledinterference)producesalessriskycashflow.
Impliesthattheentrepreneurcanbepunishedbyallocatingcontroltoaclassofinvestorswitha
conservativeslant.
Keypropertyofthecarrotandstickschemeisthattheincentivesofthecontrollinginvestorsbemade
contingentonsomemeasureofperformance.Thisisnaturallyaccomplishedasabovebytransferring
controlfromoneclassofsecurityholdertoanother.
Asingleclassofsecurityholdersmightretaincontrol,butitsreturnsstreamwouldbeadjustedasa
functionofthemeasureofentrepreneurialperformancesoastoduplicatethecontingentincentivesof
thecontroltransfermechanism.

10.4.3TheInvestorsCoalitionConundrum:IsModiglianiMillerBack?
Inthecontextofcontrolrights,thecarrotandstickargumentrequiresthatwhoeverisincontroldoes
notrenegotiatewithothersecurityholders.
Debtholderscould,forexample,designadebtforequityswapthatbenefitsallinvestors,sincetotal
investorpayoffishigherundercontinuation;orshareholderscouldinjectmorefundsandrepaysomeof
thedebtsoastomakedebtholderswillingtocontinue.
Inthecarrotandsticktheory,theentrepreneurwouldnolongerfeardebtholdercontrol,since
debtholderswouldinternalizethenegativeimpactofliquidationorconservativeinterferenceon
shareholdersafternegotiatingwiththem.
Whiletheallocationofcontrolrightsbetweeninsidersandoutsidersmatters,securitydesignis
irrelevantaslongassecurityholdersreformthebroadcoalitionwhentheyareabouttointerfere.


Counterpoints:

Thefirstisthatforsomereason(transactioncostsassociatedwithinvestordispersion,
asymmetricinformationamonginvestors,orcashconstraints)renegotiationdoesnotworkwell
ordoesnothappenatall.
Whyshouldonebotherdesigningmultiplesecuritiesifthedesiredoutcomeisthatproducedby
a100%equityfirm?
Thealternativeapproachtoreestablishingthecommitmentvalueaffordedbytheexistenceof
multiplesecuritieswithcontingentcontrolrightsistoassumethattheentrepreneurissomehow
broughtintotherenegotiationprocessandthatherpostrenegotiationutilityincreaseswithher
utilityintheabsenceofrenegotiation.

10.5InternalCapitalMarkets
Concernedwithaspecificcontrolright:theabilitytodecideandcontractonfuturefinancingdecisions.
Theabandonmentofthecontrolrightovertherefinancingdecisionisstarklyexemplifiedbythecaseof
divisions,whichcannotturntothecapitalmarketbutmustrathergetheadquartersapproval.
Thisisalsopartlytrueforstartupsthatnotonlyseetheirstagedfinancingcontrolledbytheventure
capitalist,butmustalsoconformtoothercontrolsaswell.

10.5.1HarnessingPledgeableIncomethroughExclusivity:HowInternalCapitalMarketsFacilitate
InitialFunding
Consideringatwostagefinancingdecisioninwhich,relativetotheirrespectiveinvestmentcosts,the
secondstagegeneratesplentyofpledgeableincomewhilethefirstgenerateslittle.
Externalcapitalmarket
Internalcapitalmarket
Aninternalcapitalmarket,asforothercontrolrightstransferredtoinvestors,increasesthepledgeable
incomeandfacilitatesfinancing.

10.5.2ADarkSideofInternalCapitalMarkets
ICMexposestheentrepreneurtoaholdupandtherebystiflesinitiative.
ThisholdupproblemistheflipsideofthebenefitofICMsjustanalyzed.Indeed,theideaintheprevious
sectionwaspreciselythatanICMorganizessuchaholdupsoastoallowthelendertorecouphisfirst
periodlosses.

10.5.3OtherAspectsofInternalCapitalMarkets
10.5.3.1HighIntensityMonitoring
Aninternalcapitalmarketalmostalwaysinvolvesalargeandpossiblyuniquelender(althoughlogically
thiswouldnotneedtobethecase).AsAlchian(1969)andWilliamson(1975)havestressed,internal
capitalmarketsarethereforeusuallyassociatedwithhighintensitymonitoring.
10.5.3.2AllocationamongDivisions
Incontrastwithventurecapitalandleveragebuyoutpractices,headquartersdooperatecrosssubsidies
amongdivisionsofaconglomerate.
Lamont(1997),studyingtheimpactofthe1986dropintheoilpriceincompanieswithoilinterests,
showsthatthesecompaniesdidcutinvestmentacrosstheboard,includinginnonoilrelateddivisions.
ShinandStulz(1998)similarlyshowthatinvestmentinonedivisionisgenerallyrelatedtothecashflow
ofotherdivisions.
Redistributionofliquidityamongdivisionshasbothabrightandadarkside.
FaureGrimaudandInderst(2004)comparethesensitivityofinvestmenttocashflowoffocusedfirms
andconglomeratedivisions.AkeyresultoftheFaureGrimaudInderstanalysisisthatconglomerate
divisionsexhibitareduced(re)investmentcashflowsensitivityrelativetofocusedfirmsperformingthe
sameactivity,asbetterperformingdiversionscrosssubsidizetheunderperformingones.
Thecompetitionbetweenthedivisionsforcorporatefunding(stressed,forexample,byStein(1997))
mayhaveperverseeffects,suchasexcessivelobbying(Rajanetal.2000;ScharfsteinandStein2000).
10.5.3.3ProductMarketDimension
CestoneandFumagalli(2005)showthat(endogenous)crosssubsidiesfromthemostprofitabletothe
leastprofitabledivisionsservesasacommitmentdeviceiftheseleastprofitabledivisionsarealsothose
thatfacemoreaggressivecompetitors.
GrowingempiricalliteratureontheefficiencyofICMsinallocatinginvestment.
TheexistenceofanimpactofICMsontheinvestmentpatternandshowedthattheconcernaboutweak
divisionsreceivingtoomuchcapitalattheexpenseofstrongonesshouldbetakenseriously.

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