Corporate governance
What are the elements of executive remuneration?
Fixed Pay: - Basic salary - Pension plans & health plans - Golden handshake/hello - Golden parachute/goodbye - Retention awards Executive Perks: - Accomodation, cards, golf course fees, corporate jets Incentive pay: - Cash bonus payments (usually short-term 1-3 years) - Share options - Shares (LTIPS) Clawback rules and malus provisions
Explain the US pay transparency and "say on pay"
Found in the Dodd-Frank Act 2010 1) Every 3 years companies allow shareholders to vote on whether they want an annual advisory cote on executive pay. 2) Companies need to disclose "golden parachutes" and need to have separate advisory votes on them.
Board structure of China
- Both EDs and NEDs - Two tier board - CEO Chair duality (often secretary of communist committee) - 1/3 of directors should be INEDs - Supervisory board of minimum 3 members with 1/3 representing employees (often communists). - Guanxi is important
Who is the principal in Germany?
- Constitutional obligation to use assets not just in the private interest but also public - Social market economy - Management has fiduciary duties to the company and its stakeholders
What are the potential benefits of VCs?
1) Access to entrepreneurial firms to funding (SME funding gap) 2) Efficient CG since: - Managers are put under pressure to perform due the high gearing ratios. - Majority investors have both the incentive and ability to control management. - Better alignment of interests between investors and managers due to managerial ownership incentives. 3) Little threat that the majority investor might exploit minority investors (maybe employees) 4) Reduced tax costs due to high gearing ratio (tax shield) - Good for investors (not for public due to low tax)
Who are the principals in China?
1) Central, regional or government (society) 2) Shareholders
Costs of (hostile) takeovers?
1) Cost of finance for offer 2) Fees for financial and legal advisors 3) Cost of defence against takeover bid 4) Potentially high premiums as advantages of different management team and synergies or EoS may be overestimated. 5) Cost of merging the operations of 2 or more business into 1 (adjusting to culture, CG system etc.)
Pros and Cons of CSR from shareholder value view?
1) Depends on shareholder objectives 2) Shareholders may have reasonably similar objectives which makes it easier to hold managers to account (clear PA relationship) 3) May max long term shareholder value by engaging in strategic CSR. 4) Shareholders provide risk capital: incentive to ensure efficient use of resources: - Balance risk and return - Reduce for other stakeholders - Increase economic growth (benefits everyone) 5) Depends on the efficiency of goods, labour and capital markets and no negative external effects: - Otherwise exploitation of society or stakeholders by shareholders. 6) PP problems between shareholders? - Exploitation of minority shareholders vs. overcoming risk and resource dependence.
Empirical evidence of board structure?
1) Employee representatives: - Comparatively low levels of industrial stride - Bribery scandals (VW, ThyssenKrupp) 2) Significant power of supervisory committee chairs: - Empire building (VWs decision to takeover Porsche) - Replacement of successful CEOs - Spying scandals (e.g. Deutshe Bahn) 3) Executive directors: - Empire building (e.g. Porsche's attempt to takeover VW) - Spying scandals 4) NEDs qualification and commitment in question 5) Cross-directorship networks can reduce firm risks during volatile economic conditions (recessions) 6) Long-term orientation & mutual support e.g. R&D investment, low gearing, stability during recessions.
What is the international perspective of M&As?
1) Few hostile takeover outside of the anglo-saxan financial systems 2) Characteristics of anglo-saxan system: - low ownership concentration - high investment diversification - liquid secondary markets ~results in low incentives and ability to ~become active in internal CG. 3) Hostile takeover market in the UK is more active than in the US. 4) Hostile takeovers in countries with low minority shareholder protection often related to minority shareholder exploitation.
Characteristics of VC backed firms?
1) High performance related remuneration schemes for managers 2) Pressure of management to invest in the firm's equity (managerial block ownership): - High costs of bankruptcy for the management (investment and employment) puts pressure on managers. 3) High gearing ratios - High debt ratio & high interest rates (due to higher risk for investors) 4) Block (share) ownership by outside investors (incentive and ability to control management, property rights theory) - VC representatives on BoD. 5) Multiple funding rounds
International differences in CG?
1) Insider or outsider system 2) Identity of principal: - Shareholders (minority/majority) (shareholder approach) - Employees/Trade unions (stakeholder approach) - Government (Legitimacy approach) - Creditors, suppliers & customers 3) Rights of the principal - Information - Decision rights (directors, acquisitions, executive pay etc.) - Economic benefits (profits, dividends) 4) Board of directors - Unitary boards, two-tier boards, hybrid structures - Directors' fiduciary duties - Membership rules (gender, race, nationality, qualification) - Board subcommittees 5) Executive pay (amount and structure, clawbacks etc) and tenure.
The VC business
1) Invest in firms which: - are non listed, often limited companies - usually small to medium sized (SME funding gap) - often young companies with little to no track record of financial success in the venture. 2) Funding provided by VCs tends to be in the form of equity, high interest bearing loans, and/or warrants - VCs exit strategy is usually to sell their stake in the firm off via an IPO or sale of the venture to another firm 3) VCs often provide expert advice and access to networks (resource dependence)
Internal CG of China?
1) Legacy of central planning - Industry dominated by state owned entreprises (SOEs) 2) Consequences for liberalisation - Attempt to reform SOEs via "contract responsibility" gains - Township and village entreprises (TVEs) - SOEs turned into holding companies for non-commercial assets and commercial companies to be listed on stock markets.
Private Equity: Structure of Venture Capitalists
1) Limited partnerships where the fund manager is the general partner and the other investors are limited partners 2) In most countries they are not allowed to raise funds from the general public: - private equity capital from expert or high-value investors. Also from institutional investors, 3) Traditionally VCs: - Have a proven track record as entrepreneurs or managers - Invest their own wealth in their funds and manage funds themselves - Pay is largely profit related 4) Change due to large, highly leveraged VC funds. 5) Increasingly "professional fund managers" and fee income.
What engage in CSR activities and reporting?
1) Personal Reasons of Managers - Dinner party factor - Egomania or megalomania - Religious motivations and philanthropy 2) Economic reasons (financial performance & risk) - Marketing: Reputation effects -Reporting for greater transparency to reduce investors risk perceptions (risk premiums) and increase share liquidity (reduce transaction costs) - Political influence
Pros and Cons of CSR from legitimacy approach?
1) Positive for firm and economic performance: - Society provides key resources (overcome resource constraints and reduce risks) e.g. infrastructure, education, health - Society bears risks and costs (no negative external effects) 2) Problems for managerial supervision and control (PA problems & bad economic effic.) - What is defined as society and how do different interest groups agree on objectives (PP probs) - Who holds managers to account on behalf of the society (PA Problems)
Pros and Cons of CSR from stakeholder approach?
1) Positive for firm and economic performance: - Stakeholders can provide key resources and advice (resource dependency theory i.e. overcome resource constraints) - Stakeholders also take risks 2) Problems for managerial supervision and control (PA problems & poor economic efficiency) - Stakeholders have very different, sometimes mutually exclusive interests (PP problems). - Exploitation of less powerful stakeholders or society (negative external effects) - Who holds managers to account on behalf of the stakeholders? (PA problems).
What is halal investing?
1) Requires investment to be made in accordance with Islamic principles. 2) Faith-based approach to investment management, investors often consider Halal to be a category of ethical or socially responsible investing.
So who are the principals of German PLCs?
1) Shareholders 2) Employees Shareholders and Employees elect supervisory board (agent): - Shareholders: 66% for large PLCs and 50% for small - Employees: 33% for large PLCs and 50% for small Supervisory board elect executive board (agent) Large PLC is more than 2000 employees.
Minority shareholder protection in China
1) State's policy is not to maximise shareholder wealth so it may use its control for other purposes than value-maximisation. This exploits minority shareholders. 2) Not just a problem in firms with state blockownership but also in firms where communist party has influence without owning many shares.
What is the purpose of executive remuneration?
1) To attract and retain talented managers. 2) To ensure incentive alignment. 3) To signal to managers the firms objectives preferred by the principals.
Internal CG: Executive Contracts
1) Usually long-term contracts (max 6 years) 2) Advisory vote on executive compensation but poor disclosure of remuneration details 3) Public debate about: - "Premiums for failure" relative to job-cuts - Golden goodbyes after poor performance & corruption and CG scandals. - "Reasonable limits of remuneration" 4) Drive for more performance related pay led to strong increases in total executive remuneration in large listed German companies: - Inconclusive evidence on pay/performance - Pay related mainly to firm size instead of performance - Evidence of "soft-landings" despite laws which are supposed to prevent this.
What is incorporation?
A process by which an organisation is given a legal personality which is distinct from that of its members.
What is a warrant in finance?
A right, often attached to a bond, to buy a specified number of ordinary shares from the company at a future date at a predetermined exercise price.
Hedge funds shareholder activism
A) Activist hedge funds buy stakes in healthy firms with poor share performance. B) Activist hedge funds aim to influence corporate governance to increase shareholder value via: 1) Limiting directors' entrenchment: - Improving board independence and quality (propose new INEDs; split CEO-chair duality). - Declassifying boards - Avoiding poison pills 2) Reducing firms free cash-flow to affect managers' or inside blockholders' incentives by: - increasing leverage/gearing ratio - increasing dividends & share buybacks. C) Selling off assets to outside bidders or accept takeover offers (or alternatively buy assets or firms).
Pros and Cons of shareholder rights and ownership distribution
Advantages: - Interest and ability of blockholders to control managers - Long term interests of investors (R&D, low gearing - Network reduces supply/sales/finance risks (stability during recessions) --> resource dependency theory. Disadvantages: - If managers control cross-shareholdings they might insulate eachother from external shareholders (PA theory and managerial misbehaviour) - Majority investors might exploit minority investors by pursuing perks or related party transactions (property rights theory) - Minority shareholders have little opportunity to defend their rights --> low FDI.
The Stakeholder Theory
Argues that all interest groups who have a stake in the company should be involved in its direction. This is since it is assumed that stakeholders provide the support required to ensure the continued existence of "corporations".
The Shareholder Theory
Argues that companies direction and control should be for the benefit and at the discretion of the owners i.e. shareholders. Ultimate goal is therefore shareholder-value maximisation. Due to 2 reasons: 1) Shareholder provide risk capital. Assume most risk. 2) Linked to principal-agent theory. Different groups of people have different interests. Different principals results in managers blaming bad performance on the "need to look after one group or another".
Types of shareholder activism?
Direct voice: 1) Actively voting on resolutions in AGM 2) Backdoor diplomacy 3) Proposing resolutions or calling EGMs. 4) Standing as directors. Indirect voice: 1) Talking to press, regulators, investors, potential bidders. 2) Influencing share prices via trading shares 3) Encouraging and supporting takeover offers Derivative action: 1) Suing the firm/management on behalf of the shareholders/firm.
What are the 4 aspects of CSR?
Economic responsibilities: production and sale of goods and services and the generations of profits. Ethical responsibilities: Conforming to norms which shape the organisation of society. Legal responsibilities: Adhere to societies laws and regulations. Discretionary/Philanthropic responsibilities: Voluntary activities which exceed society's minimum requirements.
How are directors elected?
Elected by shareholder AGM. Proposed by BoD or shareholders.
What are the functions of the BoD and external auditors in terms of corporate reporting?
Board of Directors: 1) Choosing internal accounting system. 2) Ensuring that financial reports are compiled. 3) Detecting fraud. External auditors: 1) Safeguarding the accuracy and consistency of financial information 2) Commenting on the economic development of the firm in the preceding year. 3) Ensuring that the directors report reflects the financial information disclosed by the company.
Majority shareholders in China
CG)SOE: - Incentive to select knowledgeable representative and engage in monitoring. - Positive impact on firm performance - Benefits come from SOE investors. - Tight control via government. (LG)SOE: - Benefits go to SOE investors. - Less pressure from government SAMB: - Benefits go to government departments, not SAMBs. - Managers are civil servants who lack expertise. - Distant control via government. - Negative effect on firm performance. FAMILY OWNERSHIP: - Founder family - Managerial representation of family - Shared benefits of control vs private benefits of control
What does economic theory say about the role of executive pay?
Can act as a performance enhancer: - Executive pay should be more performance related including long-term incentives and malus and clawback rules. - Results in more effort, diligence, risk happiness and longer horizons. Managerial power over pay: - Should be less performance related as targets and benchmarks are subject to teamwork effects, manipulation and luck. - There is a focus on shareholder agency costs at the expense of other agency costs (creditors, public --> credit crunch)
What does empirical evidence say about managerial share ownership?
Conflicting. Some show it has no effect, some says it has.
What is corporate governance?
Corporate governance is the system of rules, practices, and processes by which a firm is directed and controlled. It should promoted transparent and fair markets and the efficient allocation of resources.
Berle and Means (1932)
Diversification of large investors: 1) Reduces risk of investment portfolio. 2) Provides less incentive for participation in management. More effort needed to coordinate shareholder action (P-A problem). 3) Incentive for blockholders to exploit minority shareholders (P-P problem). Investment by small investors: 1) Incentive for blockholders to exploit minority shareholders (P-P problem). 2) Increased funding for risk capital.
Costs and benefits of M&As?
Empirical Research: 1) Shareholders of target company who sell usually improve their financial situation in the short-term. 2) Share value of bidding company often falls but depends on premiums, payment type and existence of synergies and EoS. 3) Research on long-run effects are not conclusive M&As could be a sign of PA problems in the bidding company. Research on long-run effects inconclusive: 1) General Benefit: - Control of management without investment in internal CG by a large number of shareholders. 2) Disadvantage: - Management focus on short-term goals - Cost of conducting hostile takeovers 3) Interaction between takeover market and other CG mechanisms. 4) Methodological problems in measurement.
What measures can be taken to improve corporate reporting and auditor effectiveness?
Ensure audit committees with independent and qualified members to: - improve quality of corporate reporting - protect internal audit and risk oversight - ensure auditor independence and protection from dismissal - make the CEO & CFO liable for material errors in financial statements. - Break up large audit firms. - Limit the maximum market share. Auditor liabilities: - Increase auditor liability to increase penalty for poor work - Limit auditor liability to safeguard competition in audit market - Joint audit systems (2 auditors) - Prohibit the provision of non-audit services by auditors as it might inhibit their independence
What is the resource dependence view of NEDs?
Firms that are resource constraint benefit more from non-independent NEDs (aka "grey directors"). From this view the role of NEDs is to act as boundary spanned to extend resource through accessing finance, suppliers and customers. They can also provide expert advices. More effective if they can access a large network of suppliers, customers, investors etc. Economic incentives increase their commitment to the firm.
What is the role of the CEO?
Head of a company's executive. Can sanction other executives but not always in large companies. Cannot remove executives from boards.
What is the role of the board of directors?
In the UK, the main role of the Board of Directors is to ensure management and supervision of management through joint supervision, ratification and sanction of management's action as well as the rights to manage the firm can be delegated to directors or managers.
Who benefits from auditing?
Legally: 1) Investors (shareholders) 2) Company Additionally: 3) Potential investors 4) Suppliers 5) Customers 6) Public authorities
What are the characteristics of a "managed" insider system?
Insider CG System: - High ownership concentration - Frequent interlocking share ownership - High incentive for large blockholders to participate in internal control - Loose rules on minority shareholder protection - Small and illiquid stock market - Low portfolio diversification - Hostile takeovers are rare Outsider CG System: - Low ownership concentration - Rarely interlocking share ownership - Low incentive to participate in internal control - Tight rules on minority shareholder protection - Deep and liquid stock market - High portfolio diversification - Hostile takeovers exist
Insider or outsider system (China)?
Insider System as: - High ownership concentration - Frequent interlocking share ownership - High incentive for large blockholders to participate in internal control - Loose rules on minority shareholder protection - Small and illiquid stock market - Low portfolio diversification - Hostile takeovers are rare
What are the potential problems of VCs?
Look at notes!
CG system in Germany
Mainly insider system: - High ownership concentration - Frequent interlocking share ownership - High incentive for large blockholders to participate in internal control - Loose rules on minority shareholder protection - Small and illiquid stock market - High portfolio diversification (outsider) - Hostile takeovers are rare
Internal CG: Supervisory Board (NEDs only)
Membership: 20 (AG) - 10 (European Company): 1) 1/3 or 1/2 employee representatives 2) 2/3 or 1/2 shareholder representatives: NEDs from banks, blockholders, suppliers, customers (few independent NEDs): - Benefit: Operational expertise (resource dependency theory) & fairness (stakeholder theory) - Disadvantage: Lack of independence (PA theory); bribes to employee representatives; expertise 3) Multiple directorships (code: no more than 6, legally up to 10) (resource dependency theory vs. busyness hypothesis) 4) From 2016 large PLCs are supposed to have 30% female directors (stakeholder theory, legitimacy theory, different perspectives)
PA relationships in China?
PA (Managers and Shareholders) PP conflict with the communist party or government as a "shadow director": - Support of political objectives and interests + Access to resources and contracts (RD-Theory)
What are REPO 105 transactions>
Repo 105 was a type of loophole in accounting for repurchase (repo) transactions that the now-extinguished Lehman Brothers exploited in an attempt to hide true amounts of leverage during its times of trouble in 2007-2008. These transactions are usually designed to raise short-term capital by selling assets in return for cash with an agreement that assets will be repurchased later at a predetermined prices (i.e. loan where collateral changes ownership). Some companies like Lehman Brothers, used this just before quarterly results to remove risky assets from its balance sheet.
What is the role of the chair of the board?
Responsible for convening and leading board meetings and setting the agenda. Responsible for communication with shareholders and ensuring all the directors get the right information.
Types of incorporation
Royal Charter or Act of Parliament.
Internal CG: Co-determination
Social Market Economy: 1) Article 14: Private ownership carries social obligations 2) Work Constitution Act .....
CG Activities of VCs
Service Activities (Resource Dependence) 1) Boundary spanners (access to networks and expertise): 2) Introduction of control systems: - Cost control systems of finance and operations - Employee incentive and reward systems Control & Monitoring Activities (PA Theory): 1) Monitoring of financial and operational perf. Supported by: 1) High investment and job security incentives for managers 2) Representatives on the BoD. 3) Ability to discipline and dismiss directors and managers 4) Pressure in subsequent funding rounds 5) Decision rights regarding the listing or divestiture for exit.
What are the long-term executive incentives?
Share options: - Provide a right but not an obligation to buy shares at some time in the future at a predetermined price. Can call them ESOs (employee stock options). - Usually non-tradeable LTIPs - Long term incentive plans - Conditional ESO scheme with 0 exercise price, whereby shares are awarded to eligible executives.
What is the role of the senior independent director?
Shareholder ombudsman who is available to investors/shareholders if they have concerns which have not been resolved through normal channels of communication with chairman, CEO or CFO. Also expected to control the chair if there are any disagreement on the board which involve the chair is.
What are the principal costs in a firm?
Shareholders might me myopic (short-sighted) and thus might favour decisions which are the long-term interests of the firm. P-P conflicts may arise.
What is corporate social responsibility?
The commitment of a business to contribute to sustainable economic development by working with employees, their families, local communities and society at large to improve their lives in ways that are good for business and for development.
What is shareholder activism?
The promotion of good corporate governance via: - Direct voice (active participation in CG of companies) - Indirect voice (influencing institutional framework of CG system) - Threat of Exit (responding to poor CG by imposing risk premiums: i.e. reducing valuation of company shares and potentially selling them)
What is bounded rationality?
The subjective interpretation of information based on e.g. prior experiences.
What do Credit Rating Agencies (CRAs) do?
They evaluate and grade the creditworthiness of issuers of securities by doing "due diligence" on their financial health.
Bounded rationality of managers
They have better information than principals which results in asymmetric information.
What do remuneration consultants provide?
They provide: - insight and advice about wider trends in executive compensation. - an analysis of managerial labour markets - advice on compensation and benefits practices - advice on pensions - assessment of executive compensation relative to executive performance - legitimacy in the design of executive compensation to recruit, retain, and motivate CEOs.
PA relationship in firms between shareholders and managers
This relationship is through a firm's property rights whereby: 1) right to use (managers) 2) right to income from use (owners) 3) right to transfer (owners: shares) (managers: assets)
Explain the Australian pay transparency and "say on pay"
Two strikes policy: 1) if less than 75% of shareholder support for firm's executive pay report for two years there is a vote in the AGM to "spill the board", which if passed, requires all directors to stand for re-election.
Internal CG of Germany?
Two-tier board structure: 1) Executive Board (EDs only) 2) Supervisory boards (NEDs only) - Act as audit and executive remuneration committee. 3) No agent self-supervision (PA Theory): - Retiring EDs should wait at least two years before joining the supervisory board (unless 25% of shareholders approve). In practice it still happens often as even former CEOs become chairs.
Who are the principals in the UK, Germany and China?
UK: Shareholder Germany: Employees +others China: Government + others
What are the incentives for blockownership?
Weak minority shareholder protection: - High incentive to avoid dilution or to accumulate large stakes due to risk of exploitation by managers/blockholders. - Increased ability to exploit minority shareholders (related party transaction, investor related perks). - Investors' incentive to contribute to increasing firms share value due to the impact on their own wealth. Strong Minority Shareholder Protection: - Little incentive for blockownership - Low risk of exploitation by managers and blockholders. - Limited ability to exploit minority shareholders. - Depends on investment strategy
What is a principal agent relationship?
When one person (principal) delegates another person (agent) to act on his/her behalf.
Who are the stakeholders?
Wide definition: Any identifiable or individual that can affect the achievement of a company's objectives. Narrow definition: Any identifiable group or individual on which the organisation is dependent on for it continued survival.
What is the composition of remuneration committees in the UK according to the UKCGC?
- At least 3 INEDs - Chairman may be member, but not chair, if he was considered independent on appointment as board chairman. - Committee chair needs to have at least 12 months experience in the RC.
Influence of shareholders on external CG?
1) Influencing share prices via trading shares 2) Accepting takeover offers 3) Talking to the press, regulators, investors, potential bidders
What are the solutions to asymmetric information?
Alignment of shareholders' and managers' incentives (incentive alignment): - Incentive contract for managers (share ownership, performance related pay) - Capital structure decisions (e.g. pressure via debt) Reducing information asymmetry: - Disclosure requirements for financial and non-financial information - Voluntary publication of information in excess of disclosure requirements - Verification of disclosures by auditors
Problems with using a remuneration consultant?
- Benchmarking causes pressure to ratchet up pay - There is often advice by HR director or CEO on choice or pay of remuneration consultant (dual PA relationship) - Dual PA relationship if the consultants engage in addition consultancy work such as HR and Auditing.
What are the benefits of using a RC?
- Executives don't set their own pay. - Executives don't recruit remuneration consultants. - Accountability of remuneration committee members (if shareholders don't like the pay volume or structure): (25% negative votes in Australia) - Independent appointment of remuneration consultant: Independent advice, expertise in designing incentive contracts and market knowledge.
Benefits of using a remuneration consultant?
- Expertise in designing remuneration packages - Market research: ability to recruit and retain without overpaying
What does empirical evidence say on the impact of "performance related pay"?
- Powerful CEOs increase pay-performance sensitivity in period when good firm performance is expected. - Powerful CEOs reduce pay-performance sensitivity in period when bad firm performance is expected. - Firms with Superstar CEOs tend to underperform. - Performance related pay seems to affect: accruals earnings management, real earnings management and financial decision making. However research is inconsistent. - Issue of reverse causality: Do pay increases lead to share price increases or vice versa? - Executive pay not as performance related as frequently assumed: research often ignores pensions, golden parachutes etc. - Research fails to use risk adjusted returns and to control for earnings management. - Modelling not sufficiently complex and robust.
What are the remuneration components of CEO pay?
- Value and balance are important/ - Increases in pay risks leader to increased pay demands. - Danger of unintended consequences: e.g. a positive relationship between increase in share value and increase in the value of ESOs creates incentive not to work hard, engage in fraud, manipulate financial decisions etc.
Types of board structures?
1) One-tier unitary board 2) Two-tier board 3)Hybrid system
What was the ENRON auditing scandal?
- hired by the client - paid by the client - assisted in employee outplacement efforts by the client - offered lucrative special work by the client - engaged to structure and bless the client's transactions; what is an audit firm to do when asked to "see it" the clients way? Used dubious accounting practices, including a technique known as "mark-to-market accounting," to hide the troubles. Mark-to-market accounting allowed the company to write unrealized future gains from some trading contracts into current income statements, thus giving the illusion of higher current profits. Auditor Arthur Andersen LLP signed off on it.
What are the advantages for incorporation?
1) Accumulation of large amount of capital. 2) Risk management for investors (diversification and different investment vehicles). 3) Can invest without needing to contribute to management. 4) Better division of labour duo to specialisation in management (meritocracy) and possibility to focus on invention, finance and management.
What makes a good BoD?
1) Board independence 2) Qualification and experience of NEDs 3)Board size 4) Calls for board diversity (legitimacy theory)
What are the reasons for voluntary disclosure?
1) Capital market transaction hypothesis (more transparency) - Results in lower risk premium and more liquidity which lowers transactions costs and increase share price. 2) Corporate control contest hypothesis (avoid bias): - More positive news 3) Stock compensation hypothesis (more transparency) - Avoid insider trading - More stock liquidity which lowers transaction costs and increases share prices. 4)
Who sits on the Board of Directors?
1) Chair of the board: Can be (I)NED, or executive chair, or CEO duality 2) Executive Directors (CEO, CFO, CTO..) 3) Non-executive directors: grey directors (ties to firm) and independent NEDs (no economic or personal ties). 4) Company Secretary: present to ensure compliance and responsible to the board for the CG compliance reporting. Helps the Chair and NEDs regarding access to information.
What authorities regulate takeovers and mergers in the UK?
1) Competition commissions 2) The financial conduct authority (FCA) 3) Panel on takeovers & mergers: - Self regulating body - Rulebook on conduct - Decides sanctions in case of breach of rules
What are the factors that make investors reluctant to directly intervene in a firms' CG?
1) Cost/Benefit: Portfolio diversification & low ownership concentration. 2) Free-riding of competitors. 3) Fiduciary duties of directors which are owed to the firm and all shareholders. 4) Insider trading rules may limit them. 5) There may be conflicts of interest.
Why is there asymmetric information between shareholders & managers?
1) Difficulties of assessing the quality of managers during the application process. 2) Managers have better information about the business and its environment. 3) Owners have difficulties supervising managers and evaluating their activities (may result in moral hazard). 4) Difficulty in communicating objectives.
What are the general principals of the UK takeover code?
1) Equal treatment of shareholders 2) Transparency and reliability of information 3)Limited strategies for takeover offer and defense: - Actions by BoD which jeopardise offer need to be ratified by shareholders. - No introduction of defence once bid is imminent. - Strict timetable (once a year only) 4) At least 50% of stock needs to be accumulated for a successful bid. 5) Shareholders with 30% or more need to offer all others to buy their shares. 6) Directors' advice must favour shareholders. 7) Shareholders of the target make the decisions (shareholder of bidder can stop the process)
Hedge funds PA relationship
1) Hedge fund managers invest a large amount in the funds and have strong performance related pay. Current trends are 17% of profits and 1.4% admin fee. 2) Hedge funds don't provide other services to companies they invest in. 3) Hedge funds tend to be independent, i.e. not owned by the companies they invest in. 4) Hedge funds investors used to be predominantly rich private investors with a keen incentive to monitor the funds. Nearly 2/3 of assets are now drawn from pension funds, endowments and other institutional investors.
Empirical research of hedge fund shareholder activism?
1) Hedge funds earn more from their activist investments than from others. 2) Findings on the impact on firm performance is not consistent: - Shareholder activism by hedge funds leads to an improvement of target firms short-term share price performance and long-term operating performance. 3) Top performing activist hedge funds focus on a few large firms with high agency costs: - Within 5 years higher returns on assets, sales growth and investment in R&D but no difference in gearing or dividend compared to other activist hedge funds. 4) Hedge fund strategies to increase gearing and reduce free cash flow might make the firms vulnerable to macroeconomic shocks, in particular credit crunches.
Characteristics of hedge funds
1) Hedge funds have a less diversified and more concentrated investment strategy than "traditional" institutional investor. -Higher incentive + lower costs of shareholder activism. 2) Compared to VCs and other private equity investors (such as buy-out specialists), hedge funds only tend to buy small blocks rather than majority stakes: - Influence can be increased by cooperation with other hedge funds, trad. institutional investors and proxy voting agencies. Empty voting by borrowing votes from other investors. - Usually no "taking firms private" through management buyouts or buyins. - Limited control & monitoring activities.
What are the reasons for corporate reporting?
1) Identifying promising investment opportunities (profitability, risk, return of an investment) 2) Taxation purposes 3) Marketing to investors as well as stakeholders 4) To reduce PA problems by reducing information asymmetry through monitoring and control and incentive alignment. 5) Reduce PP problems between investors and other stakeholders by reducing information asymmetry.
What controls the impact of blockownership?
1) Identity of blockowners (manager, family, bank, institutional investor etc. 2) Quality of minority shareholder protection of the market and in the firm. 3) Existence of other blockholders (colluding or competing) 4) Company's free cash flow 5) Managerial incentive contracts 6) Competitiveness of the goods and capital markets the firm operates in. Existence of hostile takeover market.
Explain the UK pay transparency and "say on pay"
1) In the UK there is an annual advisory vote on remuneration in the AGM: - For each executive director report on the individual components of pay and a single figure. - Report on performance measures for bonuses and degree to which they have been achieved. 2) There is also a 3 year binding vote on pay policy: - Information on how each director will be paid - How pay is linked to different levels of performance - Policy on recruitment (golden hellos) and exit payments 3) There is a public register to "name and shame" firms with more than 20% of votes against remuneration reports. 4) There is a publication of CEO-median worker's wage ratio and male/female pay ratio.
What are some general points about CRAs?
1) Influences investor perception of the risk of a security. 2) Attraction of customers (changing principals): - paid by issuer/companies of own the security (90% of CRA income) 3) High degree of market concentration (3 of 11 CRAs do more than 75% of US market ratings) 4) Ratings shopping by issuers (thought less than before the credit crunch)
What is the CG function of financial analysts?
1) Investment analysts put pressure on firms to improve transparency and accuracy of corporate reporting. 2) Investment analysts forecast growth and earnings expectations: - Puts pressure on managers to perform. - Puts pressure on managers to manipulate earnings, take excessive risks and pursue short-term (myopic) policies. 3) Many analysts owned by investment banks (principal??)
What are the consequences of voluntary disclosure?
1) It depends on the reliability of the disclosure such as investor behaviour, cost of capital (risk), share price, liquidity etc. They need to verify disclosure via external qualified "neutral" experts such as auditors and credit rating agencies.
What are the challenges related to incorporation?
1) Lack of control by owners if they do not participate in management (lack of incentive to control because of diversification; lack of ability to control because of limited power) 2) Potential of exploitation by managers 3)Potential of exploitation of external owners by internal owners. 4) Potential of exploitation of minority shareholders by majority shareholders.
What does empirical research say about financial analysts?
1) Lead and co-lead underwriter analysts' forecasts are much more optimistic for shares of companies they act for as underwriters, than other shares. 2) Lead and co-lead underwriter analysts' forecasts are much more optimistic than those provided by unaffiliated analysts. 3) Forecast optimism is more important than accuracy for analysts' career.
What makes a market ripe for corporate control?
1) Liquid secondary markets 2) Low ownership concentration and high level of diversification (disincentive to engage in internal control) 3) Transparency of firm performance 4) Rules which ensure fairness in takeover process: - Panel on Takeovers and Mergers (LSE)
What are the problems of remuneration committees?
1) Potential for NEDs to collude with EDs: - Reappointment as NEDs. - Board sets pay of NEDs while NEDs on RC set pay of EDs. 2) Tendency to ratchet up pay: - Own importance. - Firm's reputation. - Own experience with executive pay (most NEDs are or have been EDs in other firms). 3) Overreliance on remuneration consultant: - Accept the remuneration consultant's pay recommendations without understanding it.
What makes "Voice" more appealing?
1) Reduced "exit option" makes voice more attractive but limits portfolio diversification. 2) Large CG scandals can threaten the performance of a portfolio (e.g. ENRON) 3) In the UK there is an committee code for institutional investors regarding their responsibilities: - monitor investee companies - have a voting policy and aim to vote shares - provide transparency about voting intentions. 4) Reputation effect may overcome free-rider problems.
How does CG influence the market for corporate control?
1) Replace incompetent management without the need of cooperation by a large number of shareholders. 2) Put pressure on management teams to continuously perform well in order to avoid threat of takeover.
Derivative action shareholders can take?
1) Suing the firm on behalf of the shareholders. 2) Suing the management on behalf of the firm.
What are the agency costs in a firm?
1) Supervision and control mechanisms used to reduce asymmetric information between principals and agents such as corporate reporting, auditing, NED general meetings etc. 2) Aligning agents' incentives to those of principals through performance related pay, managerial ownership etc. 3) Residual losses 4) Legal regulation through e.g. Disqualification Act of 1986.
What are the benefits of incorporated firms?
1) They are a legal entity distinct from its members. 2) It is possible to distinguish between property of the corporation and the property of its members. Thus, it is possible to limit the liability of the members for debts of the company and to limit the liability of the corporation for person debts of its members. 3) Limited liability allows for freedom of transfer shares. 4) A corporation exists in perpetuity.
What are the key characteristics of financial analysts?
1) To buy, sell and hold advice to shareholders. 2) Uses company filings, meetings with management, business press, industry knowledge. 3) Paid for by investors(=principals).
Influence of shareholders on internal CG?
1) Voting on resolutions in AGM: Appointment of directors, auditors etc. dividents, acquisitions, divestitures, "say on pay" etc. 2) Talking to managers & directors (backdoor diplomacy). 3) Proposing resolutions of calling EGMs. 4) Standing as directors.
How to fight or avoid a bid?
AVOID: 1) Multiple voting share system (e.g. facebook) 2) Lack of proxy access 3) Offer other shareholder rights to buy shares instead of bidder 4) Crown jewel (sell of assets if bid successful) FIGHT: 1) Greenmail (buy out unhappy shareholders at a premium) 2) White Knight (find investor who offers friendly takeover) 3) Pacman defense (reversal) 4) Legal (file law suits) 5) Financial response (buy back shares, increase dividends)
Legitimacy Theory
Argues that firms need to legitimise their existence and operations to society to support them. i.e. in return for being provided with a legal framework to operate in as well as access to markets, firms consent to meet certain expectations society have set out.
What are hedge funds?
As "non-traditional" institutional investors: - Aggregating funds from a range of other "expert" or "professional" investors. - Providing investment expertise and risk-management. As "non-traditional" private equity investors: - Limited partnerships where the fund manager is the general partner and the investors are limited partners.
Explain the cash-flow rights and control rights problem
Exploitation of minority shareholders by blockholders likely when disparity between voting rights and cash flow rights related to the blockholding is high. Occurs when: 1) There are share with multiple or limited voting rights. 2) There is an interlocking share ownership, especially a pyramidal ownership structure such as Telecom Italia.
What are the reasons for external auditing?
External auditing is needed because: 1) There are economic consequences of information and those who use it (asymmetric information can lead to moral hazard). 2) There is complex information which requires expertise to interpret and validate. 3) There is disaggregate information which needs to be compiled for users to understand. 4) There is importance of public confidence in the accounting system for the stability of financial systems.
What is the PA view of NEDs?
From a PA perspective NEDs provide supervision of management behaviour and act as an informant of shareholders. NEDs are also supposed to develop managerial incentives and sanctions. As such, from a PA perspective, INEDs are favourable as they provide a more objective assessment of management as: 1) less involved in designing the firm's policies 2) less dependent on the CEO's goodwill 3) fewer economic incentives (via pay or blockholdings) to manipulate short-term firm performance.
Analysts' PA Relationship
Investor (principal) hires analyst (agent) to do research. Analyst (agent), on behalf of an investment bank (principal), evaluates issuer of security. The issuer of a security (principal) does loan underwriting for the investment bank (agent).
External Corporate Governance
Mechanisms which are imposed on companies from the outside, such as the external (managerial) labour, goods and capital market, external auditing and accounting requirements etc.
Internal Corporate Governance
Mechanisms which companies can influence internally such as the BoD, sub-committees, internal auditing and accounting practices, remuneration practices etc (within limits set by law).
What is the UKCGC for audit committees?
Membership: - at least 3 INEDS (2 for NON-FTSE350 companies) - at least 1 member of the audit committee has recent and relevant financial experience. - committee as a whole shall have competence Responsibilities: - monitor integrity of the financial statements and review significant financial reporting judgements - review internal financial controls and risk management systems - monitor the effectiveness of internal audit activities - monitor independence of external auditors - safeguard whistle-blower procedures
Property rights view of NEDs
NEDs with ownership interests have more economic incentive to: 1) hold management to account (reduce PA problems) 2) support firm performance 3) exploit minority or outside shareholders (PP problems)
Remuneration committees
Nobody should be able to set their own pay and thus there are remuneration committees responsible for this. Their responsibilities include: - Setting remuneration for all executive directors, senior management & the chairman. - Appointment of remunerations consultants. - Review of remunerations policies across the firm.
What is limited rationality?
Not all available information is used due to the cost of decision making.
Effect of shareholder activism on corporate performance?
Potential reasons for improved financial performance: 1) Reduced risk premiums: - Exploitation by managers or majority shareholders via compensation, perks, shirking or "tunneling" 2) Reduced transaction costs: - transparency/less risk results in higher liquidity. Empirical evidence: 1) Success in changing CG systems. 2) Inconclusive results on impact on corporate performance: - Boards reluctant to engage (more positive results for backdoor diplomacy) - US: fear of introduction of entrenchment tools - Limited differentiation between institutional investor types
Explain the market for corporate control
Property rights are transferred to those investors which value them most highly (offer highest prices) 1) Takeover bid due to hopes for synergies between bidding and target firm. 2) Investors or managers perceive a company as poorly managed (scope to increase performance): - Aim: internal control of company's management - Means: pay premium to current investors. Competition between rival management teams: 1) Takeover bid 2) Defence 3) see Kraft's hostile takeover offer for Cadbury in 2009/10.
What are the potential disadvantages of managerial share ownership on firm performance?
Property rights view: - If there are outside minority investors, they will bear at least some of the costs of managerial blockholders' misbehaviour. - Managerial blockholders might promote related party transactions. - Highly concentrated managerial blockholders might want companies to diversify in order to reduce their risk (managerial risk aversion): Minority investors use portfolio diversification. PA view: - Entrenchment effect: it is difficult for the other managers or investors to influence or dismiss managerial shareholders.
What are the potential benefits of managerial share ownership on firm performance?
Property rights view: - Managers with higher ownership stakes reap more benefits of their hard work and suffer bigger losses for poor decisions (incentive alignment). - Managerial blockholders who waste company resources have to carry part of the resulting costs themselves (incentive alignment). PA view: - Managerial blockholders have interests which align with outside investors if wealth effects of share price changes outweigh wealth effects managers derive from executive remuneration.
Advantages and dangers of PA relationship?
Pros: 1) Benefits from cooperations and specialisation. Cons: 1) Differences in preferences between agent and principal. 2) Asymmetric information. 3) Opportunistic behaviour may occur (moral hazards and adverse selection).
Pros and Cons of family ownership?
Pros: 1) Intrinsic motivation of founders and founder families. 2) Family reputation at stake. Cons: 1) Lack of differentiation between family and firm. 2) Related party transactions between various firms owned by the same family. 3) Nepotism and the "idiot son problem".
Impact of Hedge Funds shareholder activism?
Short-term (myopic) perspective: 1) Increase the risk profile of companies due to higher gearing and less diversification. 2) Break up long-term relationships with different stakeholders for short-term gains. 4) Contra: - value often realised by re-selling of shares - no evidence of less investment in R&D Exploitation of minority shareholders: 1) "related party transactions" between firms owned by hedge funds 2) Forced bankruptcy to expropriate vultures Exploitation of other stakeholders: 1) Bondholders: increased firm risks reduce market value of corporate bonds. 2) Reducing pension provisions and laying off staff.
Why do investors traditionally rely on "Exit" over "Voice"?
Short-term investors: - Reliance on discipline enforced by liquid capital & takeover. Long-term investors: - Threat of selling shares disciplines managers. Stock prices rise if long-term investors hold their positions (revealing positive information) and it falls if they sell.