Corporate Governance Introduction

1
Corporate GovernanceIntroduction

• More general thing than financial contracting
• Definitions
• Shleifer and Vishny the ways in which the
  suppliers of finance to corporations assure
  themselves on getting a return on their
  investment
• Zingales governance system as a complex set of
  conditions that shape the outcome of the ex-post
  bargaining over the quasi rents that are
  generated in the course of a relationship

2
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

3
Basic framework
NPV is positive
Incentive scheme E gets w if success, 0 if
failure.
Incentive compatibility (no private benefit
extraction)
Setting w at we get that
the financing is feasible iff
4
Pledgeable income exceeds the investors outlay

• The basic idea of corporate governance
  increase pledgeable income through the reduction
  of private benefits (insider opportunism,
  self-dealing, expropriation).
• It should be done in the least costly way
  (optimal combination of the corporate governance
  mechanisms)
• too much focus on shareholder value maximization
  can lead to inefficiency! (later on that)

5
Mechanisms

• Large investors monitoring and control
• Reduce (discourage) managerial opportunism
  (self-dealing)
• But involve costs
• Lack of diversification
• Lack of liquidity
• Pursuing own goals at the expense of other
  investors
• Takeovers
• Ex-ante effect managerial discipline
• Ex-post efficient allocation of assets
• Value increasing takeovers should succeed
• Value decreasing takeovers should fail
• Boards of directors
• Minority shareholder actions (litigation, proxy
  fights, shareholder activism)
• Executive compensation
• Other (bonding) mechanisms (adopting GAAP,
  independent auditor, indep-t registrar, cross
  listing, dividend policy etc)

6
Boards of directors

• One-tier and two-tier boards
• Approves many types of transactions (except for
  most important), appoints managers, sets
  executives pay, etc
• Appointed and removed by shareholders
• Supposed to protect shareholders and oversee
  management
• In reality are often captured by the management
  or controlling shareholders
• Hence, in theory, need for independent directors
• But empirically board composition does not seem
  to matter!
• However, severe endogeneity problems

7
Executive compensation

• Meaning aligning managers objectives with the
  shareholder value maximization ? 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 90s ? high
  pay-performance sensitivity
• 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
• Moreover, there are dangers of stock options
  manipulation of performance measures, timing of
  good and bad news releases (e.g. Enron)

8
Minority shareholder actions

• Proxy Fights
• Dissident shareholders (or group of sh-s)
  attempt to win a corporate vote on the removal of
  the current management
• Often occur in takeovers
• Not very common, especially outside the US
• Median stake of the dissident sh-r 9.1
• Empirically, provide some discipline

9

• 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.
• Empirically, little effect (US, UK)
• Shareholder litigation
• Mainly US phenomenon.
• Most suits are settled out of court
• Very little effect on shareholder value
• Possibly excessive litigation
• Overall, minority shareholder actions are rare
  outside US and UK.
• Russia Hermitage case (see Dyck, Volchkova and
  Zingales (2005))

10
Other (bonding) mechanisms

• Adopting US GAAP, IFRS (IAS)
• Hiring an independent auditor
• Hiring an independent registrar
• Cross listing (listing abroad)
• Sound dividend policy

11
Large shareholders monitoring and corporate
control

• Suppose
• Hence, no financing is possible.
• But assume that a monitor can decrease B to b lt B
  at cost cA.
• NPV is reduced
• But pledgeable income may go up!
• If
  I - A
• then financing becomes possible!

12
Overmonitoring?

• Assume that b is a continuous decreasing function
  of the monitoring cost c
• In this fixed investment model the optimal
  monitoring is determined by
• pHR (b(c)/?p) c I A
• But c is endogenous if too strong incentive is
  given to a monitor (large shareholder), he may
  well choose c gt c ? overmonitoring!
• Hence, maximizing shareholder value may not lead
  to an efficient outcome
• Other examples of overmonitoring
• Pagano and Roell (1998) (previous module),
• Burkart, Gromb and Panunzi (1998) (killing
  initiative next lecture)