Corporate Governance

How do the empirical findings of Hall and Liebman (1998) compare to Jensen and Murphy's (1990) findings? (max. 2p)

Both Jensen and Murphy (1990) and Hall and Liebman (1998) analyze CEO pay performance sensitivity. (1p) Jensen and Murphy conclude that the sensitivity of CEO pay to performance is relatively low (weak pay-performance link). (1p) Hall and Liebman conclude that the sensitivity of CEO pay to performance is relatively high (strong pay-performance link). (1p)

Broader Definition of Corporate Governance

Broader definitions of corporate governance reflect that other stakeholders' interests and concerns matter and should somehow be internalized as well. (1p)

2 Tier BOD

Performance and Conformance roles are separated. Management Board is responsible for Performance Supervisory Board is Responsible for Conformance (Most common in Europe)

Greenmail

targeted block stock repurchases, as the perhaps most controversial takeover defenses of all. To defend against a hostile takeover, management using the company's money, purchases at a premium the raiders block of the target's stock. It can be considered as a form of collusion between management and the raider at the expense of other shareholders. (1p)

Conformance Role of BOD (2p) SEPA

-Supervising executive activities -Providing Accountability

Adam Smith Opinion on Joint Stock Companies

Adam Smith, believed that directors of companies, being the managers of people's money; could not be expected to treat other people's money as their own. As they had little to no incentive to take care of the interests of other shareholders. He implied: Principal Agent problem Moral Hazard problem

Moral hazard

Arises when a contract or financial arrangement creates incentives for the parties involved to behave against the interest of others

Principal-Agent Problem

Arises when the Agent interest is not alligned with that of the principal

Executive Director

Executive directors are employees of the company with managerial responsibility. They are part of the top management team

Explain what the factor F(X) represents. Use in your answer the net dollar benefit to the firm of the optimum level of X (i.e., B(X*)). (Jensen and Merklen) Fig 1

F = B(X*) - B(X); dollar cost to firm as managers do not pursue X = X* (1p) Alternative answer: Difference between optimal level, which equals B(X*), and employed level of non-pecuniary benefits; represents dollar cost to the firm. (1p)

Explain what the value F(X) = 0 represents. (Jensen and Merklen) Fig 1

F = B(X*) - B(X*) = 0; dollar cost to firm is zero as managers pursue optimal perk consumption set from a firm value perspective.

Why coordinated action by intitutional investors or groups of investors may impact negatively stock prices ?

First, institutional shareholders or coordinated groups of investors typically approach management to negotiate privately. (1p) In case management opposes, discontent shareholders issue public proposals, which might send a negative signal to other market participants (corporate governance issues), which might result in negative stock price reactions. (1p)

Explain what Kim, et al. meant by this new aspect on moral hazard. (max. 1p)

Large financial institutions felt that due to their systemic risk (i.e., their bankruptcy causing a chain reaction through an economy) they were to "big to fail". Because in case of failure the entire financial system would be at risk, the government (i.e., taxpayers) would be forced to bail them out. This causes a moral hazard problem because large financial institutions are insulated from bad outcomes. The problem manifests as excessive risk taking, a so-called "head I win, tails you lose" mentality, leading to the practice of "privatizing gains, socializing losses". The latter means that the benefits of a risky strategy largely flow to the financial institutions, while the costs of a risky strategy are largely born by taxpayers. (1p

"scorched-earth policy"?

Management sells, possibly at a low price, assets which the raider is particularly interested in to make the firm less attractive to the raider. (1p)

Provide two reasons why the sole owner wants to sell (1-) shares to outside investors. (2p) (Jenssen and Meckling) Fig 1

Sell shares to diversify his total investment portfolio (1p) or use the cash to go on holidays, buy real-estate, buy presents, etc. (1p) For use in consumption (1p), Diversification of his wealth (1p), or more importantly, for the financing of profitable projects which he could not otherwise finance out of his personal wealth.

In his lecture Michael Viehs explained several facets of shareholder engagement that can be used by shareholders to approach management and to alter certain business practices. Name four different facets of shareholder engagement. (4p)

Shareholder engagement facets Class action Lawsuits Media Campaign The Wall-Street-Walk Hedge Fund Activism Private negotiations (dialogue) Shareholder resolutions

Why is the UK market a good market for comply or explain ? (3p) SRDBPIF

Shareholders had relatively strong rights (1p) UK listed companies faced a dispersed shareholder base (1p) Significant presence of UK pension and insurance funds seeking a long-term return on their investments (1p).

Disadvantages of Comply or Explain.

Shortcomings of the "comply or explain" principle method are that a high cost of compliance may create an expectation within a company that investors would regard noncompliance as justified, but there remains the risk that the company's assessment of this issue would not be the same as that of investors, not least because assessment of the cost of compliance is largely subjective. (1p) There can be reasons why sanctions by the capital market are unlikely to be imposed (e.g. because the company is performing well). If investors are unlikely to question governance practices, the risks to the company may be regarded as relatively low, even if non-compliance is a recurring event. (1p) In many countries, flexibility is already a major feature of the governance structure established by a company's articles of association where there are relatively few mandatory rules relating to the structure and composition of the board of directors or the respective powers of the board and the general meeting. (1p)

1 Tier BOD

Single BOD encompases both Performance and Conformance Roles. Can be composed of both Executive Directors and Non-executive Directors

Why small boards get bigger returns ?

Small boards at major corporations foster deeper debates and more nimble decision-making. There's more effective oversight of management with a smaller board. Small boards are more decisive, cohesive and hands-on (1p). Small boards are more likely to dismiss CEOs for poor performance—a threat that declines significantly as boards grow in numbers (1p) A possible reason for these findings is that director free-riding increases when board get larger. Alternatively one can mention here arguments put forward by Tricker, i.e., the time each director has to contribute to discussions is more limited, directors may form cliques or cables, chairmanship becomes difficult, there is less consensus. (1p)

Poison Pill

Special rights of the target's shareholders to purchase additional shares at a low price or sell shares to the firm at a

Disadvantage in combining CEO and Chairman roles.

The CEO is the primary manager of a company and the chairman is the head of the board, which oversees management. When combining the two roles in one person oversight is impaired leading to potential abuse of power by the CEO.

When outsiders buy a stake of (1-) in the firm, what is the value of the residual loss and explain who has to bear this loss in Jensen and Meckling's framework? (1p)

The value of the residual loss is V*-V'. The original owner-manager bears the residual loss. (1p)

Main differences between hall and Jensen ? 2p

Two factors explain the difference in findings: (1) Different time periods of study: the pay-performance sensitivity has risen dramatically since 1980, largely due to the increased use of stock option grants. (1p) (2) Jensen and Murphy focus only on how CEO wealth varies relative to changes in firm value. Measured in this way, firm size matters a lot in interpreting their measure of pay to performance sensitivity. Hall and Liebman additionally use other performance measures. (1p)

Performance Role of BOD (2p) SFPM

-Strategy Formulation -Policy Making

Explain what counterparty risk means in relation to the situation in the CDS market during the financial crisis 2007-2009. (max. 1p)

A financial instrument that played an important role in the vicious circle resulting in the financial crisis of 2007-2009 was the credit default swap (CDS) written on collateralized debt obligations (CDO). A CDS acts like an insurance contract because, in exchange for payment of regular premium, the insuring party agrees to pay the entire amount of the contract if there is a default on the underlying loan. On many of these CDS deals AIG played the role of the insuring party. AIG wrote 1.6 trillion in CDS contracts, mainly to other US banks. While CDS contracts can reduce repayment risk for banks, there is another risk involved called counterparty risk. For a bank insured by AIG, this is the risk that the AIG cannot pay in case of default. Given the trillions in outstanding CDS contracts between the major banks and AIG, bankruptcy of AIG would instantly cause many major banks to fail because of the lost CDS protection. Not surprisingly, AIG was first in line for a government bailout. The lack of surprise on the side of AIG about the government's willingness to bail them out, can explain the excessive risk that AIG took by massively selling CDS contracts. In turn, the limited counterparty risk perceived by major banks ("AIG will not be allowed to default"), explains the excessive risk taking in creating and buying CDOs. (1p)

Dual-Class Ownership Structure

A type of share division in which companies issue shares that have differing rights. In a dual class ownership structure, the company can issue two classes of shares, Class A and Class B. These classes may have different voting rights, but they represent the same underlying ownership in the company. Read more: Dual-Class Ownership https://www.investopedia.com/terms/d/dual-class-ownership.asp#ixzz5Bq0xKl7f Follow us: Investopedia on Facebook

Explain to what extent the Parmalat case can be considered to be a particular Italian case? (max. 2p)

First, the complex and concentrated ownership structure of Parmalat likely allowed the family to expropriate minority shareholders. While such complex and concentrated ownership structures are not unusual in Italy, they are also common other continental European countries. (1p) Second, Parmalat did not comply to best practices in Italy about the number of independent directors in the board and the internal control committee. Although this likely contributed to the scandal, one can argue that Parmalat is atypical for Italy in this respect. (1p) Third, the lack of separation of the chairman and CEO likely contributed the embezzlement. Because lack of separation of these two functions was usual among large Italian companies at the time, Parmalat can in this respect be considered typically Italian. While lack of separation of the chairman and CEO role is also common in other countries, like for example the US, one can argue that the lack of separation is more dangerous in combination with strong concentrated owners such as in the case of Parmalat, were both positions were being held by a Tanzi. (1p)

What is the underlying philosophy of the comply or explain principle? (3p) FRE

Flexibility: this is based on the judgment tha tit is not possible to adopt a "one size fits all" approach to corporate governance codes Role of capital markets: the market will monitor compliance with a code and will either penalise non-compliance through lowering share prices or accept (for whatever reason) that non-compliance is justified in the circumstances. Ex ante rules: ex-ante rules attempt to control "principal-agent" issues ex ante by creating board structures and procedures that will minimizethe likelihood of any question of breach of fiduciary duty arising.

Explain what is special about the corporate governance structure of Henkel. (2p)

Henkel is a partnership limited by shares (KGaA). In such partnership, one of the partners is called the "personally liable partner". This personally liable partner has unlimited liability with respect to the company's creditors. (1p) What is special in the case of Henkel, is that the personally liable partner is not a natural person, but rather a joint stock entity (AG). (1p) Further, all the shares in the AG are held by the KGaA. So, the KGaA is the sole shareholder of the AG, which in turn is the sole personally liable partner of the KGaA! As a result, the corporation is a "unified company" referred to as Henkel AG & co. KGaA. (1p) As can be seen in the figure, both the AG and the corporation as a whole (i.e., AG & co. KGaA) have a supervisory board. (1p) The supervisory board of the corporation is co-determined, meaning that half of the board consists of worker representatives. (1p) Its rights however are more limited than the supervisory board of the AG, as it does not appoint the members of the management board. (1p) The supervisory board of the AG is (indirectly) elected by the shareholders via a special shareholders' committee. (1p) Importantly, the shareholders' committee is not co-demined (i.e., no representatives of workers), thereby avoiding much direct influence of workers and unions. (1p). Because the supervisory board of the AG appoints the management board of the AG, the shareholders have firm control over the corporation. (1p) Albeit not as special as the unified company structure, also relevant in the case of Henkel is that the corporation has a dual class share structure with ordinary shares and preferred shares. (1p) Only the ordinary shares have voting rights. (1p)

Which internal and external corporate governance mechanisms could assure that financiers get a return on their investment?

Internal mechanisms Board of directors Executive compensation / Incentive contracts Managerial stock ownership Shareholder engagement External Mechanisms Market for corporate control Ownership structure Large creditors Legal protection Product market competition Shareholder engagement

White Knight

Managers look for an alternative acquirer with a friendlier attitude towards the existing management and who is willing to bid up the price. (1p

Explainwhy the cost of equity capital decreases for firms that voluntary disclose their CSR achievements. (1p)

More information is shared to capital markets (1p), which fosters risk sharing and might lower the covariance with other investments (lower equity beta) and hence lower cost of equity capital. (1p) Max 1p for this question

Discontent shareholders also have the option to vote with their feet and apply the infamous "Wall-Street Walk". What are three major complications of institutional investors applying the Wall-Street-Walk strategy?

Most stock markets are rather thin; an institutional sale would imply major stock price movements (1p). Furthermore, it is difficult to sell blocks of shares (1p), and institutional investors are not able to easily sell shares as these are part of index trackers (1p).

Comply or Explain Principle

Mostly UK, NL and DE. Compliance of principles and best practice provisions is not mandatory(1p). Rather than setting out binding laws, government regulators set out a code, which listed companies may either comply with, or if they do not comply, explain publicly why they do not. As such, the "comply or explain" principle is a disclosure obligation.

Non-Executive Director

Non-executive directors (also called outside directors) are not employees of the company and have no managerial responsibility. They are not part of the top management team. (1p)

Main role of Chairman

Oversight of management.

Priority Stock

Provide privileged voting rights to shares that are held for an extended period

Explain what they mean with "deep pocket" solution in relation to the financial crisis of 2007- 2009. (max. 1p)

The deep pocket solution refers to the fact that the US government was able to bail out several large financial institutions in the wake of the financial crisis. (1p)

Narrow Definition of Corporate Governance

The narrow definition of corporate governance is preoccupied solely with investor returns, and the ways in which corporate insiders, in particular directors and managers, can credibly commit to return funds to outside investors. (1p) "The narrow view corresponds to the "financial economics perspective". (1p)"

Explain why the gross agency costs exceed the net agency costs. (2p) (Jensen and Meckling) Fig 1

The owner faces a drop in firm value from V* to V' (gross agency cost). However, he gets partly compensated by an increase in non-pecuniary benefits. As a result, his utility loss (net agency cost) is smaller than the loss in wealth (gross agency cost). (2p)

What is meant with the term "paying CEOs like bureaucrats"?

When CEOs are paid like bureaucrats there seems to be no/low correlation between firm performance and CEO pay.