corporate governance

corporate governance mechanisms

1. giving incentives to managers 2. financing with debt 3. monitoring senior mgt 4. using proxy fights 5. engaging in take-over battles

managing agency conflict

academic studies have supported the notion that greater managerial ownership is associated with fewer value-reducing actions by managers. but it also makes managers harder to fire. so the general idea is to align managers' interests with shareholders' interest.

apple

backdating of executive stock options

proxy contests

disgruntled shareholders can introduce a rival slate of directors for election to the board this gives shareholders an actual choice between nominees put forth by management and the current board and a completely different slate of nominees put forth by dissident shareholders.

dual class shares and the value of control

dual class shares (one with voting rights and the other not) when one class of a firm's shares has superior voting right over the other class ex: a class B share might have ten votes for every one vote of a class A share controlling shareholders will hold all or most of the shares with superior voting rights and issue the inferior voting rights to the public

inside directors

employees, former employees, or family members of employees

giving incentives to managers

equity or stock options can give managers incentives to maximize shareholder value and reduce agency problems some believe that CEO incentives are not strong enough (CEO pay rises only $3.25 for every $1,000 of shareholder value created) others believe that incentives are poorly designed

tunneling

when a shareholder who has a "controlling interest" in "multiple firms" moves profits away from companies in which he has relatively less cash flow rights towards firms in which he has relatively more cash flow rights ("up the pyramid") ex: issue loans that are not expected to be repaid, overpaying for goods and services, selling assets at below market price consequence: bankruptcy

captured

a board of directors whose monitoring duties have been compromised by connections or perceived loyalties to management.

leveraged restructuring

a change of capital structure that leads to a considerable increase in debt -with more debt in capital structure, managers can't waste money if there is constant pressure to meet interest payments -commits managers to paying out FCF -managers work very hard so they don't lose their job through default of the company

pyramid structures

a way for an investor to control a corporation without owning 50% of the equity, whereby the investor first creates a company in which he has a controlling interest. -this company then owns a controlling interest in another company -the investor controls both companies, but may own as little as 25% of the second company

leveraged buyouts (LBOs)

an LBO is an acquisition of a target company or business by an LBO consortium where a significant percentage of the purchase price is financed through debt. -usually sponsored by private equity firms -all shares of existing shareholders are bought by an LBO consortium LBO consortium assumes corporate control and changes management the LBO is owned privately; the firm's shares no longer trade on the open market -when the LBO is led by the firm's old management, it is referred to as a management buyout (MBO)

exercising takeover pressure

an external corporate governance mechanism if managers don't maximize shareholder value, outsider may take over firm, fire management, run the firm better, and create value

outside (independent) directors

any member of the board of directors other than an inside or gray director

shareholder voice

any shareholder can submit a resolution that is put to a vote at the annual meeting recently, unhappy shareholders have started to refuse to vote to approve the slate of nominees for the board

employees

are most likely to detect outright fraud because of their inside knowledge

imclone systems

asymmetric info CEO tipped off family members (and martha stewart) that the FDA would deny approval of the drug Erbitux

lenders

carefully monitor firms to which they are exposed as creditors

does SOX work?

companies are certainly more aware of governance, and directors spend more time overseeing senior mgt changes in the structure of audit committees and in the choice of external auditor have been carried out overall, companies are implementing changes

notes:

corporate governance is a system of checks and balances that trades off costs and benefits -tradeoff is very complicated -no one structure works for all firms -good governance is value enhancing and is something investors in the firm should strive for

the cadbury commission

following the collapse of some large public companies, the UK govt. commissioned someone to form a committee to develop a code of best practices in corporate governance

spin-offs

full flotation of a subsidiary by distributing subsidiary shares in the form of dividends to existing parent shareholders -a new and independent company is created by detaching part of a parent company's assets and operations -can improve incentives for managers -announcement of term is usually associated with a positive stock market reaction

evidence on agency problems

if managers announce actions (the "event") that investors don't like, then stock prices fall. thus, such actions do not maximize shareholder value.

cross-holdings

in the US it is rare for one company's largest shareholder to be another company's the norm in some other countries

CG

in the US, the board of directors has a clear fiduciary duty to protect the interests of the shareholders most other countries give some weight to the interests of other stakeholders in the firm, such as employees

management entrenchment

large investors have become interested in the balance of power between shareholders and managers

pay and performance sensitivity

the use of stock and option grants in the 1990s has lead to a substantial increase in management compensation some negative consequences: -manipulation of earnings forecast releases -backdating of options

governance engineering

main source of value in LBOs incentive realignment: -large equity upside -most rewards from buy-outs are derived from capital gains on the sale of flotation of the business, not from bonuses. -require management to co-invest active monitoring: -smaller boards, more frequent meetings -PE investors do not hesitate to replace poorly performing management

financing with debt

managers can't waste money easily if there is constant pressure to meet interest payments thus, agency problems are (like taxes) another reason to favor debt -especially in mature "cash cow" firms that generate cash but don't have good investment opportunities

agency problems

managers do not bear the full cost of their decisions since they don't own 100% of the firm

agents

managers or control

stock and options

managers' pay can be linked to the performance of a firm in many ways grants of stock or stock options to executives -give managers a direct incentive to increase the stock price. -tie managerial wealth to the wealth of shareholders

HealthSouth

manipulation of cash flows top executives orchestrated massive accounting fraud to boost earnings

threat of takeover

many of the IRRC provisions concern protection from takeovers. one motivation for a takeover can be to replace poorly performing management an active takeover market is part of the system through which the threat of dismissal is maintained

controlling owners and pyramids

much of the focus in the US is on the agency conflict between shareholders and managers in many other countries, the central conflict is between what are called "controlling shareholders" and "minority shareholders" -there is usually little conflict between the controlling family and mgt (usually family members)

gray directors

not as directly connected to the firm as insiders are, but have existing or potential business relationships with the firm

Arthur Anderson

obstructed an SEC investigation into the collapse of Enron -shredding documents (but was caught on email)

insider trading

occurs when a person make a trade based on privileged info ex: knowledge of an upcoming merger announcement, earnings release, or change in payout policy penalty: jail time, fines, and civil penalties

incentives and comp policies - negative consequences

options are often granted "at the money" (exercise price is equal to current stock price) managers have an incentive to manipulate news releases so that bad news comes out before option grants (lower the strike price) and good news comes out after options grants (option is in the money right after good news release) evidence suggests that many executives have backdated their option grants -backdating is choosing the grant date retroactively to a date when the stock price was lower than its price at the time the grant was actually awarded, so executive receives a stock option that is already in the money

securities analyst

produce independent valuations so close that they can make, buy, and sell recommendations to clients

the SEC

protects the investing public against fraud and stock price manipulation

SOX

ratified after all recent accounting scandals. it imposes new responsibilities on corporate executives and boards ex: CEOs and CFOs must attest the financial information of the quarterly and annual reports -audit committees need to be independent (=have no ties to exec mgt) and hire outside auditors -companies need to have a system for employees to lodge confidential complaints

corporate governance

the system of controls, regulations, and incentives designed to minimize agency costs between managers and investors and prevent corporate fraud. role is to mitigate the conflict of interest that results from the separation of ownership and control. avoid unduly burdening managers with the risk of the firm.

principal-agent problem

separation of ownership and control in modern corporation. benefits: limited liability, professional mgt, shareholder diversification, etc.

monitoring senior management

shareholders delegate monitoring to the board of directors (in particular, "outside" directors) auditors also perform monitoring on behalf of shareholders lenders also monitor (to protect their collateral) poorly-performing managers do get fired monitoring may prevent the most obvious agency costs close monitoring is costly

shareholder approval

shareholders must approve many major actions taken by the board. for example, target shareholders must approve merger agreements.

principals

shareholders or owners

using proxy fights

shareholders organize themselves to fight management "free-rider problem" - why would you exert the effort to fight management - let your neighbor do the work recent trend in monitoring by shareholders: shareholder activism

BoD

smaller boards are associated with greater firm value and performance. -smaller groups make better decisions than larger groups

adephia communications

stealing/fraud founders used hundreds of millions of dollars in company money or company-backed loans to fund the Buffalo Sabres hockey team among other things

Enron

stealing/fraud + manipulation of cash flows used aggressive accounting to hide massive debt and inflate the bottom line -enriching top execs. in the process

activist investor

takeover threat; shake up in the upper management and the board

what do watchdogs like SEC do?

the SEC requires public companies to file quarterly and annual financial reports using GAAP. if corporate fraud occurs, action can come from multiple sources, including the SEC, state and federal prosecutors, and class-action lawsuits by private plaintiffs

protection of shareholder rights

the degree to which investors are protected against expropriation of company funds by managers and even the degree to which their rights are enforced vary widely across countries and legal regimes

equity carve outs (aka partial spin offs)

the flotation of a minority stake of a subsidiary's shares through and IPO for cash. -a sort of corporate reorganization in which a company creates a new subsidiary and IPOs it til later, while retaining control -usually, up to 20% of subsidiary shares is offered to the public -transaction creates two separate legal entities - parent company and daughter company - with their own boards, management teams, financials, and CEOs -announcement is generally associated with a positive stock market reaction

Sarbanes-Oxley Act (SOX)

the overall intent was to improve the accuracy of information given to boards and shareholders 3 main components: 1. overhauled incentives and independence in the auditing process 2. stiffened penalties for providing false info 3. forced companies to validate their internal financial control processes.

board of independence

the role of the independent director is really that of a watchdog. however, they have less incentive to closely monitor the firm. personal wealth is likely to be less sensitive to firm performance.