PAM3340 Final

the risk externalization argument

"moral hazard" exists for stockholders problem with risk externalization argument? is a subset of the moral hazard argument equity people get the benefit but they won't bear the cost. BUT, if price adjusts (higher interest rates) it is not an externality, the price of the bonds will adjust, they will demand a higher interest rate for the same firm, downgrade debt rating, debt covenants is it fully addressed? probably not, but mechanisms have developed over time to fix it.

Adam Smith, the wealth of nations

"the directors of such joint stock companies, however, being the managers rather of other peoples money, than of their own, cannot be expected that they should watch over it with the same anxious vigilance with which the partners in a private corporation frequently watch over their own."

state owned enterprise (TVA, postal service)

(BAA Amtrak) the state's citizens are the residual claimants

empirical effects of defensive measures

-anti takeover measures reduce value, as event studies show for example, super majority approval amendments lead to a 3% decrease in abnormal return adoption of poison pills under no takeover threat decreases abnormal returns by .54% for firms under takeover speculation already, this decrease is 1.51%, if takeover is in progress when adopted, then decrease is 2.3%

characteristics of a good board member

-engaged and diligent -healthy skepticism- you have to be able to fully question management if need be. -independent -diversity in membership and thought -open and candid atmosphere, dissent acceptable -functions with trust and respect interacts with management in a constructive manner, demands full disclosure and transparency you don't want to have an adversarial relationship, you want to interact in a constructive manner. management needs to provide all the info needed to let BOD do their job. explain successes and problems and they have to do so in all their glory.

Benefits of allowing IT

1. Increased stock price efficiency- informational efficiency of stock prices, more info about firm is quickly incorporated into the price of the stock 2. helps reduce the agency problem- management updates his or her compensation package, adjusting the risk exposure incentives of the executive to create new GOOD information are enhanced, would reduce the agency problem 3. management can dial in their risk preferences, typically they would be risk averse

Steps in a firm's decision process

1. initiation: the generation of proposals for asset use and contract structure 2. ratification: the choice of initiatives to be implemented 3. implementation: the execution of initiatives 4. monitoring: measuring performance and giving rewards these steps are divided into: decision management: initiation and implementation (usually done by managers) decision control: ratification and monitoring: typically done by the board of directors

the business judgment rule is efficient because:

1. judges are not schooled in business practices 2. fiduciary principles protect residual claims also, litigation is costly.

uphold any decision

1. made by an independent board of directors acting disinterestedly 2. made after careful and informed deliberation 3. reflected in the meeting minutes directors should not permit managers to pay huge sums of shareholders money to avoid possible loss of control. a poison pill gives the board veto power over any bid for the company no matter how beneficial to the shareholders.

merger trends

1. mergers occur in waves 2. within a wave, mergers strongly cluster by industry.

costs of allowing IT (to shareholders)

1. perverse incentives- dealign the incentives of the management with that of the shareholders -manager may want to induce volatility. 2. to destroy value. ex. release the name of the target, reduce value to the shareholders of the target price of the target firm will increase, making an acquisition more expensive 3. create bad news/ short selling

benefits of the corporate form due to risk diversification

2 key types of risk: systematic: system-wide, non-diversifiable, associated with global financial market movements. non-systematic risk- or idiosyncratic risk, this is firm specific or diversifiable by definition, investors can diversify away non-systematic risk by holding many stocks where non-systematic risk is zero, then the investor is said to be fully diversified. think of the equity (stock) investor as "charging" the firm for the service of bearing risk (i.e.) providing risk bearing services. how does the investor charge the firm for risk? how does the firm pay? the price of risk bearing services is the expected return on equity relate this to the firm's cost of capital the investor will charge the least amount possible for risk bearing when she is fully diversified fourth benefit of tradability it the lowest possibly cost of equity capital

big pay cut for chipotle bosses

20 outbreaks of e coli they are paid in stock options the market is probably more important in this case cause was never determined for the outbreak think of the corporation as tending constantly towards shareholder maximization

poison pill

A poison pill is a tactic utilized by companies to prevent or discourage hostile takeovers. A company targeted for a takeover uses a poison pill strategy to make shares of the companys stock look unattractive or less desirable to the acquiring firm. There are two types of poison pills: 1. A "flip-in" permits shareholders, except for the acquirer, to purchase additional shares at a discount. This provides investors with instantaneous profits. Using this type of poison pill also dilutes shares held by the acquiring company, making the takeover attempt more expensive and more difficult. 2. A "flip-over" enables stockholders to purchase the acquirer's shares after the merger at a discounted rate. For example, a shareholder may gain the right to buy the stock of its acquirer, in subsequent mergers, at a two-for-one rate.

shadow bank

A shadow banking system refers to the financial intermediaries involved in facilitating the creation of credit across the global financial system, but whose members are not subject to regulatory oversight. The shadow banking system also refers to unregulated activities by regulated institutions.

staggered terms

A staggered board consists of a board of directors whose members are grouped into classes; for example, Class 1, Class 2, Class 3, etc. Each class represents a certain percentage of the total number of board positions. For example, a class is commonly comprised on one-third of the total board members. During each election term only one class is open to elections, thereby staggering the board directorship.

ceo PAY

ANNUAL bonus plan- paid annually based on a single year's performance.

macaroni defense

An approach taken by a company that does not want to be taken over. The company issues a large number of bonds with the condition they must be redeemed at a high price if the company is taken over.

saturday night special

An obsolete takeover strategy where one company attempted a takeover of another company by making a sudden public tender offer, usually over the weekend. This merger and acquisition (M&A) technique was popular in the early 1970s when the Williams Act required only seven calendar days between the time that a tender was publicly announced and its deadline. Catching the target company off guard and over the weekend, effectively reducing its time for a response, often afforded the acquiring company an advantage.

systemically important financial institution

Any firm as designated by the U.S. Federal Reserve, whose collapse would pose a serious risk to the economy. Systematically important financial institutions became the target of legislation and regulatory reform by the Obama Administration, due to issues concerning their consolidated supervision and regulation, following the financial crisis of 2008.

asset managers do not equal banks

Assets not held on manager balance sheet Pass through price changes/losses investors bear losses No access to Discount Window No guarantees of principal Fee-for-service model Large managers have decentralized decision-making Differently regulated

Judges incentives and the business judgment rule

BJR effectively substitutes manager's judgment for that of courts and judges judges, with hindsight, do not second guess managers, not that CEOs must often decide quickly and with limited info legal presumption is in favor of manager's judgment is that a good idea? consider judges versus manager's incentives? do we want a judge to decide how much info CEO should have before making a decision? no, judges are not chosen for their business acumen. only bring in courts for serious violation of fiduciary duties (i.e. for very high agency costs), analogous to the use of voting

CEO compensation

CEOs usually justify getting paid a lot because they take risks, their compensation provides appropriate incentives for this risk. Repricing subverts the entire justification of the option grant, which one is supposed to align the interests of shareholders and management with both an upside and a downside. below water options average face value of stock options to CEO has doubled from mid 1980s-1990s large signing bonuses CEO compensation continues to rise as CEO tenure shrinks. 1. senior managers who do not own much company stock may not be guided by what is in the best interest of long term investors. 2. strong clawback policies may discourage CEO from taking questionable actions that temporarily lift share prices or accounting numbers but ultimately result in financial restatement 3. majority of compensation should be based on performance and pay related risks should be dislocated, 4. lucrative special perks can be a sign that the board is in the CEO's pocket, can also harm EE morale 5. can indicate poor succession planning and a weak compensation committee if there is not internal pay equity. 6. stock options should be indexed to a peer group or should have an exercise price higher than the market price of the common stock on the grant date and or vest on achievement of specific performance targets that are based on challenging quantitative goals. 7. does the company reward below median performance 8. lavish post employment compensation can hurt morale, the company and shareholders. 9. a company's choice of pay peers can have a major impact on the size and structure of compensation. 10. proxy disclosure of all feeds paid to the compensation committees, consultants or its affiliates. there could be manipulation of peer groups- everyone likes to be in the same peer group as the highest rating companies so they appear to be moderate by comparison. huge discrepancy between CEO and other top executives is bad. CEOs should not make more money than what they were entitled to if they stayed backdating- allows execs to decide which date in the past would be the good date for the stock priced, picked the date with the lowest stock prices in history making the options automatically in the money. spring loading- setting the option grant just before the announcement of good news, bullet dodging is setting the option grant after the announcement of bad news. golden hellos- signing bonuses transaction bonuses

AIG

Carl Icahn- activist investor will get two seats on AIG's board. he will appoint someone form his financial firm because he is busy with other companies he is involved in.

Least cost organizational form

Case's analysis draws attention to the best organizational form for a particular task If a firm is chosen, then it must be less costly to allocate resources within the firm that through the market Most efficient (least cost) way to allocate resources will be chosen. Forms of organization/institutions (corporations, partnerships, non-profit, etc) compete with one another. Can choose the best form depending upon what activity participants want to perform e.g. corporate form might be best for steel mill or auto manufacturing non profit might be best for education or art museum partnership might be best for consulting only the best form for that particular activity will survive over time

corporate social responsibility

Corporate social responsibility, often abbreviated "CSR," is a corporation's initiatives to assess and take responsibility for the company's effects on environmental and social wellbeing. The term generally applies to efforts that go beyond what may be required by regulators or environmental protection groups. CSR may also be referred to as "corporate citizenship" and can involve incurring short-term costs that do not provide an immediate financial benefit to the company, but instead promote positive social and environmental change.

founding CEO but is still involved with the company

Jerry Moyes the board is appointed by the shareholders to uphold their best interests be sure the assets of the firm are being used to maximize shareholder value sitting on a board with a founding CEO could exacerbate the agency problems, policy of lending against corporate resources to the CEO you want the stock price to go up to goose the stock price. this is why the founding CEO is pushing for the buyback regardless of whether or not that would be good for shareholders. this board only has 6 members. number of directors that maximizes shareholder value.

Tyson foods

John Tyson- chairman, family that founded it is still heavily involved Class b vs. class a shares, one type of shares has more voting power. the class with more voting power's mostly owned by the tyson family, the family is going to vote in their best interests and that may not be in the best interests of other shareholders SEC requires you to file some extremely detailed info about your corporation shareholders know these things and prices can reflect this information, dual class voting stock makes the company more difficult to take over. ford motor company- issued tons of common stock without any voting rights, people bought it anyway because they saw the potential upside. part of tyson's contract for his CEO-ship is to be able to use the planes, he is not doing it behind anyone's back. the company is so big because you can sell tradable claims all over the world

empirical effect of takeovers

Michael C. Jensen and Richard S. Ruback, "The Market for Corporate Control: The Scientific Evidence," 11 Journal of Financial Economics 1983, 5-50. provides a meta study of abnormal stock price changes abnormal percentage stock price changes associated with successful corporate takeovers abnormal percentage stock price changes associated with unsuccessful corporate takeovers gains to bidders may be understated due to information on acquisition programs already known by the public most studies only measure the effect of each additional acquisition, which is an incomplete measure Schipper and Thompson look at when the acquisition program is announced. they find the abnormal return of 13.5% in the twelve months prior to the "event" month bidders are larger than targets, so the same dollar gains translate into smaller percentage gains precision of the estimated gains is lower for larger equity values (so economic gains could be split evenly and would work out to different % changes) overall, targets gain, and bidders do not lose- takeovers create net value (i.e. they are not just a wealth transfer) average percent gains for both target and bidder combined is about 10.5%

exchange rules

NYSE endorse certain rules of corporate governance there is a great deal of scrutiny before you can trade on the exchange.

famous insider trading cases

R Foster Winans- was going to write about 2 stocks, before he did, he insider traded $51k Ivan Boesky- 100M paid to SEC to settle 50M profit he made on insider trading Business Week/Jackson Callahan- used info from business week before it was published reading bank industry merger information Martha stewart- obstruction of justice of insider trading case

government sponsored enterprise

RC's are the government

law as product, "competition is good" view

Ralph K Winter "state law, shareholder protection and the theory of the corporation" cary ignores the many markets in which corporations much operate! product, capital, labor, etc corporations much compete in a highly competitive capital market to attract investors (like an entrepreneur ): firms are constantly searching for new capital (e.g. corporate bond market) key point: investors must be ensured of return over time (note that ability to exit an investment is critical) managers cannot exploit investors they cannot attract firms must adopt rules that enhance the security of that investment view state level incorporation as creating a market for legal rules

Kelo decision

SC case, acquire a strip of property in new london, sell to a private real estate developer, wanted to buy these properties, re-development them and public purpose was the eliminate urban blight, and to generate tax revenue public purpose was not really public use.. tear it down, you're compensated public use was a strip mall the SC granted them the right to the land forcing a transaction but compensating them for it

Sherwin Williams and Valspar

SW is acquiring Valspar SW is a very big company, paying a 41% premium to Valspar's shareholders bankruptcy and liquidation is extremely expensive why would they pay a premium for this? access to a different customer base ward off other bidders worth more together than alone this does not seem like an unfriendly takeover might increase prices because of reduced competition this merger would create market power

shadow banks

Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without explicit access to central bank liquidity or public sector credit guarantees. (Pozsar, Adrian, Ashcraft, Boesky - FRBNY), but ALSO...activities that involve transformation, including Asset-backed Commercial Paper (ABCP) Repo Securities Lending Collateralized Debt Obligations (CDO's, CLO's) As an illustration of shadow banking at work, consider how an automobile loan can be made and funded outside of the banking system. The loan could be originated by a finance company that pools it with other loans in a securitization vehicle. An investment bank might sell tranches of the securitization to investors. The lower-risk tranches could be purchased by an asset-backed commercial paper (ABCP) conduit that, in turn, funds itself by issuing commercial paper that is purchased by money market funds. Alternatively, the lower-risk tranches of loan securitizations might be purchased by securities dealers that fund the positions through collateralized borrowing using repurchase (repo) agreements, with money market funds and institutional investors serving as lenders."

can boards dismiss a derivative shareholder suit?

Strictly speaking, boards do not have power to "dismiss' a shareholder suit. This is slightly over-simplified, but the basics: What happens is that shareholders bring a demand to the board to file a claim of action. The Board then has a choice of whether or not to pursue the claim. If the board decides not to pursue the litigation (maybe this is what you mean by dismissing) the shareholder can then go to court and claim that the board is biased and not capable of making an objective decision over whether to pursue shareholder derivative litigation whereby the shareholder brings litigation (usually against an individual officer) on behalf of the company. The Board can also file a motion in court to dismiss the suit, which the court can grant or deny. Not sure how often this whole process takes place but I would imagine it is fairly common for shareholders to propose suits that the Board decides not to pursue

golden parachute

Substantial benefits given to a top executive (or top executives) in the event that the company is taken over by another firm and the executive is terminated as a result of the merger or takeover. Golden parachutes are contracts given to key executives and can be used as a type of antitakeover measure taken by a firm to discourage an unwanted takeover attempt. Benefits include items such as stock options, cash bonuses, generous severance pay or any combination of these benefits. such contracts can reduce the agency conflict, since the incumbent managers know they will receive this high pay if they are removed, then they are less likely to resist a change in control. recall how managers can block a takeover if they wish data indicate that the stock price of firms rise by about 3 percent upon announcement of adoption of these contracts

application of agency costs in free cash flows

Takeovers: Oil Industry example from 1973 through late 1970s. Oil profits were rising while there was excess capacity in distribution and refining (so no need to invest) Led to a situation in which there was lots of free cash flow Industry was spending it on wasteful research and exploration (also tried to invest outside the industry, like utilities getting into real estate, another example of free cash flows) The price of oil stocks was very low as a result incentives for takeovers of oil firms

Sarbanes Oxley Act of 2002

The Sarbanes-Oxley Act of 2002 (SOX) is an act passed by U.S. Congress in 2002 to protect investors from the possibility of fraudulent accounting activities by corporations. The Sarbanes-Oxley Act (SOX) mandated strict reforms to improve financial disclosures from corporations and prevent accounting fraud. SOX was enacted in response to the accounting scandals in the early 2000s. Scandals such as Enron, Tyco, and WorldCom shook investor confidence in financial statements and required an overhaul of regulatory standards

lead director

The new role, lead director, offers an alternative to splitting the combined chairman-CEO role. The lead director serves as an independent chief among all board members and thereby helps ensure board relations run smoothly. One feature of Sarbanes-Oxley, clarified by regulations issued by the SEC, and recently adopted by both the NASDAQ and the New York Stock Exchange, effectively requires listed companies with non-independent chairmen to elevate one of their independent directors to the position of lead director. Changes to each exchange's listing regulations mean that non-management directors must now meet at regularly scheduled executive sessions without management. Those meetings must be overseen by a lead director. Furthermore, both exchanges have indicated that those firms must communicate the identity of this person to the company's shareholders, thus creating a clear channel of communication between the firm's board and its stakeholders.

teamsters

US regulations proposed new rules on thursday to overhaul the way wall street execs are paid, addressing years of complaints that executive bonuses led to the 2008 financial crisis received pressure from the white house to complete the task pension funds- teamsters- reducing the benefits and reducing their hedge fund investments

pac man defense

What is the 'Pac-Man Defense' The Pac-Man defense is a defensive tactic used by a targeted firm in a hostile takeover situation. In a Pac-Man defense, the target firm turns around and tries to acquire the other company that has made the hostile takeover attempt.

conflict of interest

a conflict of interest arises when an executive, an office holder or even an organization encounters a situation where official action or influence has the potential to benefit private interest. NYSE enacted new corporate governance in August 2002 that required independent directors to compose a majority of the board (as opposed to earlier independence requirements that applied only to members of the audit committee) regulators rely on the industry for both information and often for future job opportunities possibility of management to use their position to enrich themselves

board of directors

a governance structure whose principal purpose i to safeguard those who take a diffuse but significant risk of expropriate because the assets in question are numerous and ill-defined. should be seen as a governance instrument of stockholders.

why would you do a stock split?

a more liquid market a trading range- you can dial that in by the splits that you do. boost the demand for the stock ownership structure of a stock: 1. tradability 2. divisibility

fiduciary duties

acting in good faith -actions taken are in the best interests of corporation/shareholders duty of care -informed, diligent in fulfilling responsibilities -reasonably prudent person standard duty of loyalty -without self interest or opportunity for personal gain business judgment rule -second guessing decisions not acceptable -assumption- directors act in the corporation's best interest by fulfilling the above duties. risks are worth it because: you remain engaged, hopefully benefitting if you own stock, people you get to meet, well compensated relative to the time you put in

the costs of monitoring management is considered to be an....

agency cost- are a type of transaction cost transaction costs are anything that arises from transacting in the market.

close corporations

also called closed, or closely held corporations much more numerous than open corporations in close corporations, little separation of owners and risk bearing (of ownership and control) recall the continuum of ownership and control managers in many close corporations usually hold most of the shares yet many close corporations are financed by debt and venture capital (which implies separation) the extent of separation determines the governance mechanisms and legal rules that apply line between public versus closely held is blurry

freezeout

an action taken by a firm's majority shareholders that pressures minority shareholders to sell their stakes in the company. termination of minority shareholders or refusal to deal them dividends you are taking away the right of minority shareholders to sell when they choose reducing the rational ignorance problem sometimes you need to compensate the minority shareholders for squeezing them out.

Institutional investors

are large investors that have a fiduciary duty to invest on behalf of a group of individuals they hold assets in trust for that group they must act in that group's interests I.I vote proxies for companies it owns eliminates/reduced the collective action problem, reduces the free riding problem they are large enough to mitigate the rational ignorance problem (i.e. the benefits to them of being informed are large.) recall how transferable RCs overcome the rational ignorance problem they are also large enough to overcome the "free rider" problem in monitoring managers who are the institutional investors: private pension funds, state/local pension funds, mutual funds, insurance companies, household sector

insurance companies

are limited in the amount of stock (equity) they can own to 20 percent, currently about 14 percent life insurers may not put more than 2 percent of the company's assets into any single insurer face conflicts: usually also hold the debt of companies they invest in often want to sell the company insurance are under no obligation to report to their customers how they voted their proxies (interesting because they are fiduciaries)

equity holders

are residual claimants of the corporate form have an actual ownership interest in the firm. shareholders are equity holders, can be other types of equity, private equity. what does the firm promise shareholders in return for providing capital? what limits the shareholder's loss? people invest equity with the expectation that it will grow you are bearing the risk of the firm- think of it as a service, you will bear the risk but you have to be paid for that. you are compensated through expected return. what else do shareholders provide the firm? the bear its risks. what limits the shareholders loss? limited liability. you are promised nothing else, except maybe 1 share 1 vote.

who are the institutional investors

as of 2006: pension private funds: 2,667 billion state/local pension funds: 1,958 billion mutual funds: 5,018 billion insurance companies: 1,638 billion household sector: 5482 billion

measuring the effects of corporate control transactions

assumption: stock prices measure investor's expectations about the firm's future discounted payouts (i.e. the value of the residual claims) a change in the price of the stock reflects a change in the investor's valuation of the company (not perfectly, but the best measure we have) stock prices will be affected continuously by new info hitting the market type of news: company specific news: new products, new governance structures, new managers, etc economy wide news: changes in interest rates, Janet yellen's statements, trade agreements, wars, etc industry wide news: e.g. regulations affecting a specific industry suppose we want to observe the effects of a specific event on a set of firms (e.g. tender offer, announcement of poison pill, etc) need to remove the effects of market wide and industry wide news to observe the effects on those firms

who are they? (board of directors)

average board size has remained at about 15, but has grown smaller and a net reduction in inside directors most come from the commercial elite, tend to be made up of current and former CEOs, of the corporate executives, lawyers, bankers, consultants, other finance experts, professors, administrators and accountants. term- staggered terms- 3 year terms, with one third of the board up for election at one time most elected on an annual basis the most popular type of director is the top executive of another company. current or retired executives, academics, leaders of nonprofits or former government officials. should have a thorough understanding of financial reports and filing obligations. there should be board member evaluation

restricted stock grants

awarding stock with limits on its transferability for a set time, usually 2-3 years, but sometimes for the executives tenure with the company. the purpose of this is to adjust pay up or down based on performance, to give a CEO a guaranteed bonus in any circumstance is to make the term itself meaningless.

anglo saxon law

based off of roman law

law of close corporations

because less separation of management and risk bearing, there is less need for outsiders on the board of directors to monitor courts generally enforce whatever agreement the parties conclude that is, courts are here enabling as well parties have wide flexibility in structuring the firm (even more than in corporations) close corporations raise the issue of minority versus majority sharholders many elements of close corporations contracts involve protecting the rights of minority shareholders (otherwise would not get investment)

corporate form

benefits of the corporation: can raise large amounts of capital costs of the corporate form: agency costs or the costs of addressing the agency problem public means putting shares into circulation, could be the first time, IPO or just issuing new shares. how do shareholders get managers to behave in the interests of shareholders? focus on the variety of mechanisms that have evolved to help control agency costs: called corporate governance

background on SEC acts

big issue in corporate law is the division os law between the state and the federal government reason to like the states: competition, innovation and evolution in law they can imitate, borrow positive and negative lessons from other states. must but not all state corporate law is enabling

SEC Acts

blanket federal fraud prohibition may be least costly mechanisms why would criminal penalties be necessary? E&F the cost of offering high quality securities go down since they are already honest, while the cost of passing off low quality securities rises without disclosure, investors view all securities as average. would there be a lemons problem? high quality issuers could voluntarily disclose, but note cost of disclosing trade secrets how could anti fraud penalties encourage securities issues to without information Note that the socially amount of investor fraud is positive! (why?) SEC's enforcement of the 1933/1934 acts has focused on the accuracy of historical facts Not on accuracy of future projections Future projections are protected by "safe harbor" Rule 175 Reason for Federal laws?: securities are held by people from many states Fraud would have to be litigated in many jurisdictions (thus a transactions cost argument

inherent tensions between board and managers

board exists to "look over the shoulder" of managers ("monitor") yet managers should be given the freedom to make managerial decisions board depends on management for its information yet directors often rely on managers for board seats (nominations) CEOs also influence the agenda and the composition of the board Board picks the CEO so they may be reluctant to criticize or remove the CEO large percentage of U.S. companies have CEOs that are also the chairman of the board. the costs/ benefits of combining the ceo/chairman? -conflicts of interest between the CEO and the chairman, competition between the two CEO on the compensation committee? NO benefits: checks and balances, agency governance say on pay exchange rules- rules about when you list on a stock exchange, corporate governance rules, audit committees have to be composed of outside directors

mechanisms to control agency costs

board of directors (with outsiders) executive compensation packages/executive removal hostile takeovers institutional investors shareholder voting outside audits bond ratings product markets Norwegian Sovereign Wealth Fund- institutional investor that comes from the money raised by drilling oil Alaska Permanent Fund- pays a dividend to every citizen of Alaska including children from oil drilled every year.

key issues on board organization

board size (number of members) -advantages versus disadvantages of more members even to odd? no ties, too many cooks in the kitchen free rider problem when you add more members diversity, fresh perspective on certain issues board composition -refers to insiders versus outsiders or independents -advantages and disadvantages of each? trend toward more outsiders? -diverse opinions -expertise -inside knowledge that an outsider definitely does not have outside- hold stock and therefore more aligned with shareholder interests? serve as a focusing agent meeting frequency average s&p 500 board met 8.0 times in 2013 trend toward less frequent meetings, may be due to increased use of committees committee structure -must have an audit committee (audit committee must be all outsiders, NYSE rules) can also have compensation, finance, nominating, environmental, corporate governance committees, etc board compensation -most paid in cash trend toward incentive pay for directors, tock restricted stock, and options about 25% of s&p 500 pays in stock more than 50% offer options some call for more board ownership in the firm ("think like shareholders"), more closely align their interests with those of shareholders.

compensation schemes

both the firm and its managers should recognize the merits of drafting compensation packages that deter both requiring the firms to make severance payments upon dismissal and managers to sacrifice non vested rights should they quit would help safeguard assets

jensen, causes of increased merger activity in the 1980s

causes of increased merger activity in the 1980s, note links to policy decisions -adjustment to deregulation in the 1970s/80s (adjusting to underlying economic change) -relaxation of antitrust laws (airlines, trucking, railroads, crude oil deregulation): when you relax antitrust laws, more and more firms are allowed to merge, economies of scale, costs have been reduced and you can produce more goods/capital -increased foreign competition (more free trade in autos): exit of land labor and capital when there is increased foreign competition, demand shifts left in the capital markets, quantity reduces, capital shifts out

what are transaction costs?

coase: transaction costs are the costs of carrying out transactions by means of exchange in a market think about why a specific firm exists: Cornell University why no use the market mechanism only to get your education? why not just purchase all the inputs yourself through a market? what would you have to do to use markets only? all of those things are done internally by cornell, you purchase those services, firms exist because markets are costly to use

legal rule

common law allows insiders to trade stock unless contract restricts them the default rule is to allow trading, this holds today unless federal law restricts thus, a lot is left up to the details of individual contracts (i.e. a very cousin approach) the default rule is you can trade on any and all information you are given in your job, as long as you are not told not to puts the duty on your employer to say certain info is proprietary

lenders

commonly make short team loans for general business purposes or longer term loans against ear marked assets as the exposure to risk increases, debt holders become more concerned with the details of the firm's operating decisions and strategic plans. with high D/E ratios, the creditors become more like SH and greater consultation between the managers and the major creditors results

stock options

company gives the option recipient the right to purchase a block of the company's stock at some specified price in the future at a strike price set at the time of the award. current trading price. can't make money unless the stock price goes up. re-pricing: re-issuing stock options when the stock price is below the option price. enormous option grants. index options- strike price rises with the stock market. compensation reflects the performance of the particular stock. oR grant the options at a strike price greater than the current stock price.

economics of close corporations

consider a firm with few managers who are also the largest residual claimants these firms often restrict managers/ investors ability to alienate RCs firm loses the key benefit of specialization of investment vs. management loses benefits of diversification! less efficient risk bearing but also major benefits of close corporations: small number of RCs reduces contracting costs and costs of monitoring other owners lower agency costs if RCs are friends or family, which also reduces agency costs no market for the RCs of close corporations exists (i.e. not tradable) this raises a set of problems for shareholders 1. no price for RCs- firm valuation is difficult transactions that do occur are few and raw between, feature high transaction costs hard to disinvest! incentive to go public? raises the issue of minority shareholders 2. lack of share market creates conflicts over profit distributions/ dividend policy 3. lack of market for stock precludes public monitoring -no market for corporate control -no monitoring by potential bidders -cannot link managerial pay to stock price 4. cannot incorporate all available information into the stock price, price signals are lost close corporations will be most efficient where those costs are lesss important, where gains are the greatest often need buyout agreements if a manager leaves a firm often used in startups of various types family owned businesses

defining insider trading

consider alternative definitions of IT parties better informed about a stock than others? but, you want to preserve the incentive to be informed. analysts are informed for a living. better informed is too vague, preserve the incentives to work hard and do productive things. parties with unequal access to information? see above^ managers and stock analysts, could anyone have been a manager or could anyone have hired the stock analyst does a stock analyst have unequal information? property rights definition of IT: there exist property rights to information within the firm, the firm can define what info can be traded on and what cannot (i.e. what remains in the firm via contracts), think of allocating property rights by contract firm can decide what info is restricted and what is not by contract firm makes very clear when you would be violating firm can allocate the property rights to trade or not to trade through contracts with employees application of property rights definition: parties lawfully in possession of information can trade on it, i.e. if they own the information parties not lawfully in possession of information cannot trade on it or pass it on (like theft) to understand I.T., focus on property rights to information, can borrow from patents, etc how can property rights to information be established? 1. hard work 2. actions of the firm you work for 3. buy it

the structure of voting

corporations can structure voting as they wish (subject to state law) note that it is priced in to the stock some patterns: typically: only shareholders vote all shares have one vote non voting stock is rare stockholders select the board and the board selects the managers majority rules obtain states place very few restrictions on voting some states ban the sale of votes separate from the residual claims, that is, the vote must stay with the ownership. law looks negatively on separating decision power from bearing the risk of those decisions. decision control with risk bearing reality.

exceptions to limited liability

courts usually uphold LL for large corporations are some exceptions: close or closed corporations only a small amount of stock trades (if any) less separation of management and risk bearing precedent- based on past case, if facts of a case are the same, the conclusion should be the same. not legislative, law evolves but slowly. stare decisis- let's stand what is decided. stable rules of the game. these companies usually have a small number of shares outstanding. OR, only a small amount of stock trades. under what circumstances? here the benefits of LL are reduced -since owners are the same as managers (or the two groups traditionally overlap), there are few benefits to reducing monitoring costs -little chance of takeovers -since investors are usually not fully diversified, no benefit from efficient risk bearing -LL facilitates large bloc holdings, but owners and managers are the same so it would be extremely hard to takeover. outside hostile takeover could only take a small sliver, and you won't have voting power. they say that in this case, you do not have limited liability.

jensen, arguments against takeovers

damages morale damages productivity more short term horizon more market power gains come from lower tax payments gains come from broken contracts with workers gains come from inefficient capital markets takeovers reduce r&d

role of delaware law

delaware is a small state by most measures half of all industrial companies are incorporated in Delaware majority of firms re-incorporate (about 80%) in delaware leading state of incorporation since 1920s delaware law viewed as good due to: highly developed corporate law (i.e. large body of precedents) sophisticated corporate bar credible commitment to be receptive to corporate needs delaware is a leader in innovative corporate laws (laws that allow corporations to adopt to new conditions) delaware quickly copies other state innovations that are value increasing

incorporating in delaware

delaware's enabling statute is particularly attractive for large firms where the benefits resulting from specialization of function are the greatest. greater statutory control is superior for smaller firms and investors prefer smaller firms that seek states with greater constraints.

the fiduciary principle

directors and officers are the "fiduciaries" of shareholders they must operate the firm in the interest of the shareholders they have a duty of loyalty and a duty of care hired by the shareholders to uphold their interests and act in their interests, you sit down with a lawyer to tell you what it means to fulfill your duty of loyalty and your duty of care. fiduciary principles are a broad set of legal rules that restrict managerial behavior legal sanctions for violating these principles are the institutional arrangements that set up the principal agent relationship economics of FP: workers and bondholders have no fiduciary relationship with the firm; why the managers?: because they make decisions on behalf of the shareholders. FP can be thought of as creating "implicit contractual terms" implicit contracts are important because contracts are always incomplete (contracts are optimally silent on some contingencies) risks- allocate them to one party or another. if a contingency clause is high in benefits, and low in costs, include it. contigencies- strike clause- high benefits, low costs- allocate to firm geotechnical- firm force majore material costs diminishing marginal benefits to additional clauses written in the contract, degree of contractual completeness. it is costly to write additional clauses, so therefore the contracts are incomplete. means there is stuff that happens where the contract is silent. you need to make a decision but it is not explicitly stated in the contract, you refer to the fiduciary principles. default rule- rule of law that can be overwritten by a contract, can be modified by agreement by the parties, mandatory rule in contract would be ones that need to be enforced even if both parties do not agree. default rules are rules where the contract is silent, you can overwrite- if you don't say anything to it, that is the rule that applies. fiduciary principles and social norms contribute to this. where contract is silent: fiduciary duties- you should think about how the parties would have done if they would have contracted. you should allocate risk to the party that could bear the risk at the lowest cost. least cost risk bearing,which party is this?

limits and obstacles to board's oversight of managers

directors can never know as much about the operation of the company as management so they are dependent on the CEO. CEOs almost always play the dominant role in selecting and inviting board members.

does the manager take on the correct risk?

do the managers have the correct incentives to take on risk? -choice of CEO -how you pay that person -these things depend on and affect the level of risk a CEO will take on and thus this effects firm value. fiduciary duties to maximize shareholder value. you are constantly trying to equilibrate things in order to maximize the value of the firm. you are constantly trying to move towards xStar, which will lead you to the highest possible vStar, given the constraints in the environment. correct amount of investment in risky projects by the firm: the amount which maximizes shareholder value arguments that they may take on too little risk? -to keep interest rates on their bonds low -job security (quiet life), this is a perquisite -firm specific human capital, bonding cost -bonding cost that shows that you are about this company and that you are investing in it. -if the company goes down, the human capital goes down with it -might be a risk averse CEO because they have invested in a lot of firm specific human capital -risk projects are high effort and may fail reasons to be risk averse 1. firm specific human capital 2. the quiet life- job tenure 3. paid in stock- one way to solve the agency problem is to pay the managers like owners, a lot of their compensation and wealth is tied up in stock arguments that they may take on too much risk? 1. limited liability 2. directors and officers insurance (ex. Chubb) introducing the incentives of moral hazard, if you are insured against a bad outcome, you are indemnified, you will therefore take more risk they are insured against judgments for actions taken in their official capacities did something in their official capacity that severely damaged the welfare of shareholders, shareholders can sue (derivative shareholder suit) but they hypothetically should have insurance against this, so this makes you less risk averse.

state incorporation

entrepreneurs who want to raise funds for new ventures bear the loss if they decide to incorporate in a state with an inferior incorporation law because investors will pay less for shares. entrepreneurs can avoid this loss if a firm goes public in a state with superior corporation law and in its last period pressure the state to adopt inferior corporate law provisions or switches its state of incorporation.

jensen: takeovers, their causes and consequences

examines the 1977-86 period unusually high takeover activity note that target firm shareholders expect to gain from takeover gains to target shareholders over 10 year period 346 billion in 1986 dollars equal to about 51% of all dividends paid to investors over that time in 1986, only 40 out of a total of 3300 takeover transactions were hostile tender offers, 110 were voluntary tender offers, 3100 were voluntary mergers (although the threat of hostile takeover remains) recall agency cost explanations for mergers jenson offers additional explanations: additional agency cost explanations for takeovers: new managers can do things that the old managers cannot. e.g. new manager may be better able to negotiate with labor new managers may be able to abandon inefficient projects that old managers are attached to.

pension funds as investors

example: California Public Employees Retirement System (CALPERS), Ontario Teachers (grows about 1 billion every 2 months), Dallas Fire Retirement Fund pension funds are very activist "although they still only represent 14.5 percent of total institutional investor assets, state and local public pension funds are overwhelmingly the most activist institutional investors with regards to corporate governance matters, and, as they increase their presence in equity markets, they increase their clout "the public funds have so much money that they find it's harder to find new companies to invest in than to try to turn around poorly performing ones. pension funds are long term investors, money is invested with them for 30 years on average. they are all trustees managers that don't perform well may lose clients governments tax policy encourages employees to save via pension funds over 30% of all equity investments in US are public and private pension funds is this a new form of socialism? worker controlled capital? unlikely: pension funds must be highly diversified public- public employees private- building trades

the community

externalities commonly arise where the parties in question do not bear a contracting relationship to one another. corrections can be interpreted as an effort by he community to impose a contract where none existed. communities that make investments in support of a firm should scrutinize the character os the investments that the firm itself makes

Federal Law: Williams Act

federal law affecting takeovers Williams Act of 1968 an amendment to the Securities and Exchange act of 1934 any person acquiring more than 5% of a publicly traded firm must file a report with the SEC (Schedule 13d) 13d filing: must state intent (investment or control) if bidding for control, must file a more details report tenner offers must remain open for about a month targets have time to maneuver (can block the bid or seek competing offers)

proxy fight

fight to win your state of directors using your mechanisms, number of directors is not fixed.

corporations changing form

firms can change forms in a lot of ways, create more shares, issue more debt, etc. don't think a bout it as much as a person- which we think of as mostly the same over time.

state incorporation

firms can change the state of incorporation through a shareholder vote states usually provides a different set of rules for small privately held "close" corporations states compete for incorporations specialization (gains)- incorporating in states more favorable to your industry or more favorable to your company, in general think about state law as being a product, specializing in different things depending on the state.

state incorporation debate: competition among states is bad

firms can choose where they want to incorporate two broad views of the role of state incorporate: William L Cary, "Federalism and Corporate Law: Reflections Upon Delaware," Yale Law Journal -this is the traditional view -if you are not allow to mobilize then you could become subject to onerous laws in a state. view is that shareholders are like customers buying a product information is asymmetric customers need protections from exploitation by firms state level corporate law is controlled by managers to effectively exploit shareholders managers choose where to incorporate based on rules that most effectively exploit investors (i.e. increase agency costs) state incorporate laws (charters) are a race to the bottom law for sale is a social problem policy implication": implies a need for a common federal corporate chartering system to eliminate competition prevailing view in 1970s- eighty law professors sign petition calling for a federal chartering system

theory of boards, fama and jenson

focus on three functions: decision management, decision control and residual risk bearing residual claimants bear risk CEO undertakes decision management board undertakes decision control hypothesis: if there is a separation of risk bearing and management functions (i.e. when a different group bears the risk of the decisions than makes the decisions) then there will be a separation of decision management from decision control i.e. will observe the board structure emerge look at several organizational forms as "data" to see if the hypothesis is correct open corporations- do see separation of risk bearing and decision management, also see separation of decision control note that there are several important control mechanisms: the stock market, market for takeovers, expert boards F&J note that these unusual (relative to other forms) monitoring mechanisms allow for more insiders on the board (recall that insiders bring more firm specific info) outsiders deal with issues where agency problems with insiders are likely to be very high, such as with audits, compensation, replacement. professional partnerships (law, accounting, consulting, etc) generally have residual claims restricted to the main professional agents (partners) residual claimants monitor each other in most partnerships, decision management and decision control are not separate (supports hypothesis), however in large professional partnerships, ownerships becomes diffuse. different people are RCs than are making management decisions scope for agency problems in large partnerships: we see a board structure evolve (i.e managing partners) see seperation of decision control from decision management as management and risk bearing become more separate financial mutuals many financial activities are organizes as mutuals (investment funds, insurance) unusual in that residual claimants are also customers (e.g. shareholders of mutual funds) here, there is separation of risk bearing (RCs) and decision management prediction is that you will observe a board structure mutual funds do have boards of directors, but there are reasons why the boards of mutuals are different, owners actually have direct control of the firm's assets owners/customers can redeem their RCs on demand using a pre-specified rule (ex. NAV) owners can remove assets from manager's control on demand owners have very strong control rights non profits no residual claimants, but have donors, who contribute "risk capital" agency problems between donors and managers separation between risk bearers and managers observe boards for non profits boards are often made up of substantial donors, who have incentives to intensely monitor donors have the risk that the nonprofit does well in the future

survival of an organizational form

for an organizational form to survive: must yield benefits in excess of its costs must also be better suited for the types of activities it is in that other forms otherwise, another firm using another organizational form could provide the product more cheaply (similar to firm using the wrong mix of inputs) the corporation has survived and prospered over time corporate form must yield benefits in excess of its costs

Implications of Tradable RCs

for example, the owner need have no other role in the firm except ownership (i.e. no management role residual claims can be traded at a low cost, so markets (stock markets) operate in those rights prices are established for the ownership rights

squeeze outs

force you to sell your interests if you are a minority shareholder the compulsory acquisition of the stakes of a small group of shareholders from a joint stock company by means of cash compensation allows one or more shareholders who collectively hold a majority of shares in a corporation to gain ownership of the remaining shares.

state incorporation debate

foundation of the federalism debate in corporate law is that revenues derived from franchise taxes provide a powerful incentive for state legislators to implement corporation codes that will maintain the number of domiciled corporations, if not lure new firms to incorporate in the state. the national government would certainly not be as sensitive to franchise tax dollars as would a small state, and practically speaking, there would be no competing sovereigns to attract dissatisfied corporations. if management chose a state whose laws were adverse to the shareholders interests, the value of the firms stock would decline relative to stock in a comparable firm incorporated in a state with value maximizing laws as investors would require a higher return on capital to finance the business operating under the inferior legal rule -subject to takeover -bankrupt in product market

agency costs of free cash flows

free cash flow is cash flow in excess of that required to fund all of a firm's positive net present value projects so what do they do with this? they take excessive trips or invest in crappy projects, they exacerbate takeover costs. issue more debt to fix this they create severe agency cost problems the problem is to get the firm to "disgorge" free cash flows (i.e. to pay it out to shareholders instead of wasting it) why don't managers want to pay out FCF to shareholders? if they need new capital, then they must go to the capital markets (debt or equity) to get it and they will be more intensively monitored (this points to the issue of intensity of monitoring when new stock/bond issues versus ongoing intensity) cash payouts reduce the resources at manager's disposal managers may value free cash flows to facilitate growth, which they value per se how can FCF be paid out? debt: debt forces managers to pre-commit to paying off the debt and thus giving up cash debt can be viewed as substitute for dividends, except that it is more binding of a promise than a permanent increase in dividends debt holders have the right to force the firm into bankruptcy if the firm reneges on its promise issuing debt to buy back stock reduces the agency costs of free cash flows going private transactions and leveraged buyouts create lots of debt, so they reduce the agency costs of free cash flows use of debt in takeovers: now even large firms are subject to the takeover threat.

bank trusts

funds that are held in trust for a principal often are irrevocable trust- cannot withdraw funds for performance often display poor performance

costs and benefits of having insiders trade

gauge costs and benefits by whether more IT increases shareholder value: what effect does IT have on shareholder wealth if there were no transaction costs, then we could contract to the optimal amount of IT (Coase Theorem) the more information that is going into the trades, creates more information efficient prices senior executives trades are disclosed. signal that the company is going to do well or do worse if a CEO is short selling their company, that would be negative benefits of IT 1. solving the agency problem 2. price efficiency 3. management can dial in pay packages do restrictions on IT increase or decrease shareholder value recall shareholder value hill if there were no transactions costs, then we could contract to the optimal amount of IT (Coase) benefits of IT? costs of IT? why would firms restrict IT? the optimal amount of IT will vary across firms

small partnership

generally the owners are the managers small owner/manager group small agency problem here

large open public corporation

great degree of separation between ownership and control owners are risk bears and capital providers big agency problem risk spreading big capital raising a lot of tradable RCs- almost all equity is tradable

delaware

has a court dedicated to these issues, you should incorporate there

corporations (closely held)

has shares that are defined, maybe that only some are transferable

universities and foudnations

have large pools of funds and alumni and corporate gifts trustees are also often board members of large companies are often loath to upset corporations may be passive investors; free riding off monitoring of others

customers

have the option to take trade elsewhere protection by third parties may be warranted instead. a regulatory agency equipped to receive complaints and screen products for health hazards could serve to infuse confidence in such markets. token representation may create only unwarranted confidence. brand names effectively extend a firm's planning horizon and create incentives for the firm to behave more responsibly

growth of institutional investors

hold 25.3 trillion of all U.S. financial assets as of 2009 (about 26.5 percent in equities) average institutional ownership in top 50 publicly traded corporations was about 64% in 2009, compared to 49% at the end of 1987 58% of microsoft 60% of GE 58% of intel 68% of cisco systems major stockholding force diverse: institutional investors are by no means a monolithic group

mutual funds

hold about 24 percent of all US companies mutual funds are also trusts but investors can easily liquidate holdings according to a pre-set rule (i.e. not irrevocable) may encourage a short term attitude toward companies in which it invests -assets are customer owned N.A.V- you sell at the NAV the players in the market are big guys

mandatory disclosure

if did not have mandatory disclosure, then firms could just remain silent firms face restrictions on advertising of stock why does disclosure have to be mandatory? firm would have the incentive to disclose if it increased firm value! that is, firm (not investors) will bear the cost of not fully disclosing through a lower stock price

GM Corver Car

if going at high speed and you cut the wheel really hard, the car would flop. also many were convertibles unsafe at any speed- ralph nader, at this time, the 1970s, there was a consumer protection movement

BJR in close corporations

if neither managers nor courts are disciplined by the market, the justification for BJR is less fair. one rational for the NJR is that managers who make errors and even those who engage in self dealing are penalized by the market forces while judges who make errors are not. managers have better incentives to make correct business decisions than judges.

close corporations legal protection

in a large open corporation, there is a separation between ownership and control, managers do not hold most of the shares in close corporations, in a derivative shareholder suit, they may not be able to reach the bar because most of the shares are owned by management have less diversification fewer agency costs

who runs the board

in most american boards, the CEO is also the chairman and is responsible for critical issues like committee assignments, setting the agenda and the quantity and quality and timing of the information provided to the board. 1. could split the two functions with an independent outside director serving as the chairman or they could have a lead director or presiding director. 2. lead director serves as the liaison for the outside directors and conducts the executive meeting sessions a presiding director is a lead director with the same responsibilities for conducting meetings. both would be expected to work with the chairman to finalize information flow, meeting agendas, and meeting schedules. ex-CEO has vast experience and probably has more knowledge in the company than anyone else.

dynamic efficiency

incentives to invest properly in the thing you bought

employee stock ownership plans (ESOPs)

incentivize employees by making them part owner of the firm.

directors compensation and incentives

increasing demands on directors are resulting in increasing pay. more boards are including stock grants as part of this agreement. stock based compensation for outside directors aligns interests with shareholders.

derivative shareholder suits

is a lawsuit brought by a shareholder on behalf of a corporation against a third party. Often, the third party is an insider of the corporation, such as an executive officer or director. Shareholder derivative suits are unique because under traditional corporate law, management is responsible for bringing and defending the corporation against suit. Shareholder derivative suits permit a shareholder to initiate a suit when management has failed to do so. Because[clarification needed] derivative suits vary the traditional roles[citation needed] of management and shareholders, many jurisdictions have implemented various procedural requirements to derivative suits.

corporation

is its own legal entity, an infinitely live legal entity, can sue or be sued.

issue voting

issue voting often takes place in cases where agency costs may be high: fundamental corporate changes charter amendments voting when not required

functioning of BOD

leadership -CEO and chairman vs non executive chairman -lead director advanced materials committees -audit (at one point this was the focus) -compensation (now this is the focus) -governance -finance -health, safety, and environment -technology -risk -public affairs meetings -executive sessions board evaluations hire outside consultants for best practices for pay- they don't do any other work for the company. other topics: cyber security, director performance, director term limits, takeover issues, chapter 11 complexities, FCPA violations, personal risk, due diligence, BOD compensation

piercing

legal case in which the court is deciding whether to pierce the veil of limited liability or not

fiduciary duties

legal duty of care and loyalty to operate the assets of the firm in the interest of shareholders (CEO, board and managers), guiding light should be what's best for shareholders.

right to vote

lies with the residual claimants the right to legally build up voting power in corporation individual shareholders decision to participate in a vote, rational ignorance and free riding. collective action problems, quality of information about shareholders preferences might be low and the cost to the firm is high. think about voting as controlling the agency cost.

Alcoa

makes aluminum, has announced that it will add 3 directors heading off a potential board fight- by splitting the company they can allow the experts in each to make calls. Disclosure- giant pools of capital that elliot management has at their disposal the company knows who its investors are, activist investing has gotten a bad reputation, in it for a quick buck sometimes. splitting because they believe the divisions are worth more apart than tighter, possibly double the current amount. diseconomies of scale, economies of scale, economics of scope activist investors can force change on Alcoa the market thinks that the activists are creating value by putting pressure on the board.

big partnership

managing partner, some separation of ownership and control.

why do firms exist?

markets allocate resources efficiently (price allocation gets to the efficient quantity where MB=MC) why worry about the firm if markets allocate well? before institutional economics, the firm was simply a "black box" or a production function, Y= f(K,L)

equity investment

may have infinite upside with minimal downside. also true with bond investments, preferred stock. would you invest if this was not true? it is not true in partnerships

economies fo scope

means the average total cost of production decreases as a result of increasing the number of different goods produced. MC= deltaTC/deltaQ size/scale in LR in the long run, there are no fixed costs, if x&y combined it is economies of scope. similar to the idea of synergies.

starwood gets rival offer from chinese group

means there was already an offer free riding evaluating the value of the company- is there unrealized value? is the market undervalued? when an offer is made, its a signal that someone thinks there is value to be hard from re-structuring others can free ride on this announcement and not put all the effort in themselves prices reveal and contain information competitive bidding process, if you're the target, you want more bidders, tender offer, takeover premium, usually 25-30% buy a bloc of shares above the market price.

additional efficiency explanations for takeovers

merger helps assets exist the industry, since can combine and sell of marginal parts that are in trouble this form of exit may be less costly than bankruptcy, since the whole firm does not have to go bankrupt can merge with the larger firm, which can retain particular parts mergers often inject additional resources into the new entity

mid cap public corporation

moderate seperation

three main components of agency costs

monitoring costs- costs of trying to control (or monitor) the manager's behavior, incurred by the principal, includes not just measuring and observing agent, but also efforts to control the agent via budget restrictions, compensation policies, operating rules, etc. residual costs- the costs of managers misusing corporate resources (e.g. extra lear jet), departures from the optimal amount of resources and effort, because monitoring is costly, will always be departures from the optimum, it is not optimal to eliminate all perks bonding costs- it may pay the agent to expend resources to guarantee (ex ante) that she will not take certain actions to harm the principal or to guarantee that the principal will be compensated if she does, costs incurred by the agent not the principal, ex. firm specific human capital- value of that knowledge in another firm is low. since monitoring is costly, the manager's incentives will never be perfect, series of mechanisms have evolved to control agency costs in corporations, much of the study of corporations addresses this question

board membership

monitoring model- central function of the board is to safeguard the interests of the stockholders. participative board- the outside board members are invited to join with the management to enhance the quality of strategic decisions. since managers enjoy huge information advantages because of their full time status and inside knowledge, the participating board easily becomes an instrument of management.

3 basic roles boards perform

monitoring role- boards select, compensate, and make implicit and explicit decisions regarding the retention of the CEO and other members of senior management overseeing the process of accounting, financing reporting, auditing and disclosure. make assessment about the performance of the company and its management assist the company in claiming and protecting its shares of external resources service role- board do help to formulate strategy acting as a sounding board for the CEO and senior management team, and providing external input into the strategic process. left to their own, managers tend to develop biased constructions of the firm's strategic position. moreover, they will be overconfident, and be heavily vested in those beliefs and hence disinclined to seek out information that would suggest they might be wrong. only by giving power to a more objective group of outsiders can the insiders be forced both to expense their biases and to take dissonant view points the most conventional justification for a critical mass of insiders is the idea that insiders bring a special and detailed knowledge of the company- its history, personal prospects, etc. that is essential to at least the service work of the board. a fully independent board can make use of whatever inside talent it wants, including inviting full participation in deliberations before moving to a vote. adding insiders can be a positive influence on the work habits of the board, or you can create more high powered incentives for outside directors, largely through stock ownership plans and compensation schemes. outsiders lack detailed knowledge of the firm's inner workers and are likely to use fairly heuristic forms of thought tied to readily observable data. if they are nonetheless overconfident in their inferences about the firm, they will not draw on insider expertise to the extent that it would be prudent. highly diverse groups are negatively associated with good performance. group think- the tendency of cohesive groups implicitly to censor non preferred points of view and any information inconsistent with what is preferred. the most productive boards seem to be ones that have enough diversity to encourage the sharing of information and active consideration of alternatives, but enough collegiality to sustain neutral commitment and make consensus reaching practical decisions within the tight time frames in which boards must operate. boards sell select, often with strong input from the CEO, choose those who will fit well with existing members. in the face of serious monitoring, the CEO will be very careful in what she does or does not tell outsiders, if the CEO senses that full disclosure will have a large enough adverse impact on her compensation package or prospects for continued employment, there is a strong last period temptation to manipulate data given to the board 3 potential costs to worry about when a board is divided between serious monitors and senior managers 1. decrease in the smooth functioning of the group as a result of identifying two separate functions with separate roles. 2. loss of valuable information by outsiders that would otherwise be provided in a trusting environment 3. increase and attention the CEO devotes to influencing activities instead of more productive tasks.

elements of transaction costs

most common definition: -search and information costs -bargaining and negotiation costs -monitoring and enforcement costs if the internet lowers TCs, what might bet he impact of firm organization?

consider agency cost effects of corporate control changes

new management team: won't be entrenched, may be able to abandon old inefficient projects or do things that old managers could not do threat of a takeover: management will work to reduce agency costs to avoid takeover, will work to maximize shareholder value going private transaction: reduces agency costs but you don't spread risk as much as much as much access to capital markets. increases in the debt/ equity ratio?: decreased agency costs, debt holders are very intensive monitors, they want to be paid back principal and interest, they will become more intensive monitors as the debt/equity ratio rises other alterations of managerial incentives?

corporate directors pay rate is higher as risks grow

non executive director- a director who has no other role in the company other than serving on the board executive director- people from inside the firm serving on the board there is an inherent tension here, it is an important balancing act. the board is inherently a mix. pay of non executive directors- climbed nearly 50% this is a part time job- 5 hours per week. shareholder lawsuits, trying to hold board members responsible for corporate failings. never take a BOD positions unless you are indemnifiable from the risk

enabling

not a lot of restrictions, you have the freedom to do what you want (delaware corporate law)

independent

not an officer or somehow clearly connected to the corporation if you are the auditor, they get a lot of compensation from the audits, they probably can't be a good outside director or even one at all. holding a lot of stock in a rival company may make you unable to be an outside director.

entrenched management

not using assets to their full value with hostile takeovers you will get control of these votes and replace the entrenched management. threat of takeover on incumbent managers... can induce them to act more in shareholders interests, managers will try to work to make sure the agency costs are low. actively use assets in the interests of shareholders.

the mythical benefits of shareholder control

notion that shareholders in a corporation have the power to remove directors is a myth - in a public company with widely dispersed share ownership, it is difficult and expensive for shareholders to overcome obstacles to collective action and wage a proxy battle to oust an incumbent board, nor is success likely when directors can use corporate funds to solicit proxies to stay in place while directors have some interest in ensuring the firm's survival, they do not have a strong financial interest in optimal corporate performance (agency cost) BUT, board governance, while increasing agency costs, also promotes efficient and informed decision making, discourages inter shareholder optimism, and encourages valuable specific investment in corporate team production. calls for greater shareholder democracy appeal to laymen, businessmen, the media, not because they are based on evidence, but because they have a strong emotional allure. comes from the misleading metaphor of calling shareholders owners of the corporation, the opportunistic calls of activist investors seeking leverage over boards for self interested reasons, and a strong but unfortunate sense that something, anything, should be done in the face of recent corporate scandals. board governance allows for efficient and informed decision making board governance deters inter shareholder opportunism board governance promotes specific investment in team production if investors truly believer more shareholder control meant better corporate performance, they could vote with their wallets, by preferring shares in firms that grant more shareholder control most IPOs include weaker shareholder rights (Ex. google- powerless shareholders, oversubscribed) the myth that public corporations are run well when they are run according to shareholder interests shareholders are owners- but corporations are there own legal entity and therefore are not actually owners of the corporation, if shareholders own corporations why shouldn't they also control them? emotional fallacy at law, a principal has a right to control her agent. directors are not agents but fiduciaries largely insulated form shareholders control and they owe duties not only to shareholders but to the firm as a whole. "sole residual claimants"- board controls payouts (dividends and corporate expenses)- therefore the shareholders are not entitled to every penny earned by the firm. employees, creditors and other stakeholders share in the wealth as well when the firm does well. particular shareholders at particular firms sometimes say they want more control. but you should look at what shareholders collectively do at the investment stage. source of imminent crisis sparked by recent large scale crises like Enron/worldcom, investors have concluded that "something must be done", easy to conclude that this something is to give shareholders more control. Enron did not collapse because shareholders did not have enough power, occurred at a time when shareholders held more power than ever more

debt holders

often called "fixed income" debt comes in many forms, can be a bank loan, credit line or bonds what does the find provide/promise bondholders in return for their capital? pay them back where do proxy rights lie? equity creditors are risk averse because they want their money back in interest, they would be very conservative in their voting if they were given notes. they have limited upside. we can categorize organizational forms through their nature of residual claims. both equity holders and debt holders provide the firm with capital.

Cousin Analysis of Insider Trading

once the property rights are assigned, then parties can write contracts that get them to the efficient amount of activity, depending on the cost of transactions contracting will allow the parties to get to the efficient amount of IT once property rights are assigned importance of 1. clearly defined property rights (right to trade on the information or not) 2. cost of contracting -the contracts would be between the firm and the employees, transaction costs assume the cost of contracting is high, so that parties cannot reach a deal internally you can't trade on insider trading in this case, you would be stuck t 0. opposite- all IT is allowed, but transaction costs are still really high, they can't internally contract because of high contracting costs you cannot do contracting around the property rights assignment so you cannot move around the optimum what if it were free to write contracts? they are going to iterate negotiations until they get as close to the optimum as possible. if you flat out deny IT and employee want sot trade, CEO pays the firm to insider trade, keep going until you get to the optimum if you allow all insider trading, the firm will pay you not to insider trade, you will not back on IT until you get to the optimum if costs are truly 0, you get to the optimum value regardless of what policy on it is. think in terms of property rights to information and how contracting can solve the problem firms may create restrictions on info through contracts with employees 1. be clear about the rights assignment 2. lower the transaction costs as much as possible, the implication is that this will help you get closest to the optimum think in terms of property rights to information and how contracting can solve the problem firms may create restrictions on information through contracts with employees patents and copyrights are examples of restrictions on information general rule: want to assign the rights to information where their economic value is the greatest if the value of the right to information is the greatest within the firm: then no IT is allowed if the value of the right to information is greatest with the manger: then IT is allowed property rights assignment matters because of transaction costs.

holdout problem

one holdout person or two or three cold stop the process of acquiring something that another finds of value. nailhouses in china are an example of a hold up problem. you can;t take without paying, but the US' constitution does give the right to take. cannot use private land for public use the transaction that you want to consume creates value

splitting the chairman and the CEO and the rise of the lead director

one key challenge of the board is control of the information and the agenda. splitting the chairman and the CEO roles became universal. "presiding" or a "lead director", something between chairman and a liaison for the outside directors has been widely accepted significant contribution of the lead director role- taking responsibility for improving board performance, building a productive relationship with the CEO, providing leadership in crisis situations, keep the board focused and the CEO informed. boards must keep minutes of their meetings and these minutes must be provided to shareholders on request. the three required committees are finance, executive, and a small but increasing number of committees devoted to environmental, science and technology and legal compliance issues. one way for directors to communicate with shareholders is to attend the annual meetings and be prepared to answer questions about the procedures followed with the audit, compensation and nominating committees. When the CEO is also the chairman, a conflict of interest arises, as the CEO is voting on his or her own compensation. Although a board is required by legislation to have some members who are independent of management, the chair can influence the activities of the board, which allows for abuse of the chair position. As the CEO is the management position responsible for driving those operations, having a combined role results in monitoring oneself, once again opening the door for abuse of the position. A board led by an independent chair is more likely to identify and monitor areas of the company that are drifting from its mandate and to put into place corrective measures to get it back on track. In 2002, the Sarbanes-Oxley Act, legislated as a response to several high-profile corporate failures, set out stronger regulations for corporate oversight, including a requirement that the audit committee consist of only external board members. This means that no member of management can sit on the audit committee. However, because the committee is a sub-group of the board of directors and reports to the chair, having the CEO in the chair role limits the effectiveness of the committee.

defining other organization forms via RCs

other forms of organizations (all of which compete with the corporate form) can be defined by the nature of their residual claims corporation- residual claimants are the stockholders, freely tradable RCs partnerships- residual claims are restricted to partners sole proprietorship- residual claims are restricted to proprietor, this is the only form where there are 0 agency costs, owner and the manager are the same person.

gray outside directors

outside directors with conflicts of interest

sole proprietorship

owner is the manager, no agency problems, no tradable RC's

benefits of tradable RCs

owner need have no other role in the firm except ownership (i.e. no management role) why is this a social benefit? --specialization of labor, you can raise money from all over the world. residual claims can be traded at a low cost, so markets (stock markets) operate in those rights prices are established for the ownership rights why is this a social benefit? -because you can quickly and objectively monitor firm performance this way if the corporate has large costs but is successful as an organization form, must be offsetting benefits what are the benefits of tradable ownerships shares? tradability of corporate residual claims creates a unique set of benefits, which are... corporations are good at undertaking capital-intensive, complex and risky activities. what are the benefits of tradable and divisible ownership shares/RCs? 1. can raise lots of capital from a large group of investors. this allows the firm to be very large, which allows firms to benefit from scale economics 2. stock prices provide an objective measure of firm performance (people are weighing in to say they value something a certain way) 3. can spread out risk among a vast group of equity investors- among a vast group of equity investors, large group is providing risk bearing services 4. lowest possible cost of equity capital

fundamental problem in corporate form of ownership

owners (stockholders-residual claimants) --> board of directors (elected by proxy- one share 1 vote) --> CEO (appointed by the board, can sometimes come with a management team), --> top managers (appointed by the CEO) --> middle managers voting rights= control rights there is a separation of ownership and control the owners of RCs are risk bearers, the assets are suppose to be operated in their interests people deciding what to do with assets are quite distinct from those owners owners and their appointed managers have divergent interests.

costs of the corporate form

owners and their appointed managers have divergent interests this is the standard problem in law and economics: the principal/agent problem -employer/employee -customer/auto mechanic -patient/dentist numerous mechanisms have evolved over time to help control agency costs Both Marx and Adam Smith commented on the agency problem in the corporation, owners are not the managers, so managers will abuse firm assets Berle and Means (1932)- the modern corporation and private property, blamed agency costs for the depression

the corporate principal-agent problem

owners are the "principals" CEO, board and managers are the "agents" Goal of owners: to maximize firm value (share value through price; homogeneity of interests) goal of managers: to maximize.. personal value, salary, perks, not always consistent with maximization of shareholder value.

open corporation

ownership shares are freely tradable you have to disclose and provide information to the market Sarbanes Oxley- enron, tyco, worldcom

information asymmetry

people who are insiders to the company have way more information than the people outside the company.

management participation on the board has three benefits:

permits the board to observe and evaluate the process of decision making as well as the outcomes. board thereby gains superior knowledge of management's competence which can help it to avoid appointment errors or to correct them more quickly. the board must make choices among competing investment proposal. management's participation may elicit more and better information than a formal presentation would permit management's participation may help safeguard the employment relationship between management and the firm, an important function in view of the inadequacy of the grievance procedure. management participation should not become so excessive as to upset the basic board purpose. independent or outside directors- directors without a financial or personal connection to management stock exchanges require listed firms to have independent directors to audit committees and courts take the board's independence into account when assessing claims in shareholder lawsuits. event study of the appointment of an outside director reports a significant price effect even when the majority of the board was already independent. could signal that the company plans to address its business problems. reasonably strong correlation between poor performance and subsequent increase in board independence. no evidence that greater board independence seems to be leading to improved firm performance, having inside directors could add value in strategic planning. heavy emphasis on teamwork and conflict avoidance makes a board captured by the CEO the more productive boards are the ones where insiders and outsiders work cooperatively and not at odds with one another.

residual claims

property rights to the net cash flows of an organization the nature of the residual claim is not the capital structure.

major responsibilities of the board of directors

protector of shareholder long term interests provide oversight of management and corporation's operations/ performance endorse strategic direction- can ensure long term value, can ensure competitive advantage and differentiation, not easy selection and evaluation of CEO including compensation- CEO has the greatest influence on the culture of the company, how the organization reacts, etc. interaction between strategic direction and selection of CEO. merger- is the deal the best offer for the shareholders? put personal feelings and connections aside. ensure business practices are in place to protect assets and enhance company performance -integrity of financial reporting -enterprise risk management -internal controls -health, safety and environmental compliance -regulatory compliance not operating the board 24/7- board members need to make sure that management is doing what it needs to do. succession planning- when CEO decides it is time to retire, you have someone in the wings to replace them.

costs and benefits of structural changes

recall the costs and benefits of the corporate form -main cost is the agency cost capital raising, risk spreading benefits if these benefits diminish in value, then it makes sense to de-corporatize the firm

auditors

required to be independent and is thus forbidden to have any economic interests in the client but the possibility for employment by the client as well as the opportunity to sell non audit services arguably compromises this stark separation.

Ray Diprinzio Guest Lecturer

research on how to finance infrastructure in the united states shrinking pool of resources and revenue that have been laid to the states. consolidation results in 3 large japanese banks, 12 institutions become 3 merged banks, 1990s financial crisis caused this. Sumitomo is a SIFI -global institution that operates all over the world use the resources of the bank to lend money on a large scale rail business- acquired railroads and locomotive leading capability A1 credit rating- close to the top strengths in the americas: project finance portfolio, construction and term loans, revolvers, working capital, project bonds, hybrid loans, bridge to bond, bank leverage, term loan b got into the business of public finance that bank gave him a good background of what state and local finance was. project finance= single asset financing the equity contributions are limited, no obligation to put in anything they haven't already. project financing is very highly levered. not as risky as you think as long as the LLC can deliver the asset on time and in budget. as an asset class, infrastructure has become recognized as a viable investment. capital markets have helped this happen. SMBC is a recognized leader in structuring public finance figure out how to finance infrastructure with a shrinking pie.

mutual (mutual fund)

residual claimants are the customers NAV- net asset value, value per unit and you can cash out at the NAV

cooperative

residual claimants are the workers, the workers own the company. ex. plywood industry (workers are homogenous)

static efficiency

resources and control allocated to a higher valued owner of resources

cash flow waterfall and residual claims

revenue --> opex --> debt service --> taxes --> equity returns who can asset a residual claim to that cash flow at the end?

event study method

ri = i + Rm + Rx + I ri = change in firm i's stock (returns) i = firm-specific intercept Rm = change in (returns on) the market portfolio (S&P 500) Rx = change in (returns on) the industry portfolio = co-variance between firm i's stock and the market portfolio = co-variance between the industry portfolio and firm i's stock i = residual or error term if the residual or error is zero, the firm is just earning a normal return the error term reflects the effect of firm specific news on that firm's stock price sometimes called the abnormal return can either be positive or negative

empirical evidence

romano shows there is a significant positive correlation between the responsiveness of a state's code and the proportion of revenue from incorporations Event studies: show positive abnormal returns associated with announcement of move to Delaware law No study has found a negative abnormal return! NB: shareholders must approve such a move Romano showed that firms typically move to Delaware prior to a major corporate event (takeover, IPO, merger) note effect of a late 1970s Delaware statutory reform permitting firms to limit directors personal liability for damage in shareholder suits is this value increasing or value reducing? within two years, 41 other states had adopted!

how corporate law mitigates the agency problem

romano views three aspects of corporate law as most critical for mitigating the agency problem 1. shareholder elected boards who monitor managers 1. shareholder voting rights for fundamental corporate changes 3. fiduciary duties that impose liability on managers if they do not act in shareholder interest but overall, delaware law is enabling intervenes only to enforce contracts and stop theft other states are more strict in their corporate law (which may be better for smaller firms) whether strict or enabling law is better may depend on the firm's capital structure

united continental

running a route directly from Newark to Smizik's because home town in NC activist hedge find- raise a public challenge to the airlines board cause after united announcement on monday to add four independent direct lines. can a proxy fight distract the company from executing on Oscar's strategic plan.

limited liability

shareholders are not personally liable for the debts and obligations of the corporation in the event those are not fulfilled i.e. liability is limited to the amount invested does this mean that corporations themselves have limited liability? no, corporation itself has unlimited liability as a legal person, the investors have limited liability bondholders also have limited liability most forms of investment have limited liability: limited partnerships, debt investors, university trustees, term LTD means limited liability who would invest without it? tradability of RC is a key feature of corporations 1. LL encourages full diversification by investors: it becomes rational to invest in a diversified portfolio 2. LL reduces the cost of monitoring other shareholders (why?): what you expect to pay in a judgment depends on the wealth of the other shareholders, how does wealth impact share value?, if other investors are really wealthy, your personal risk is less, conflicts within the firm 3. LL promotes the free transfer of shares (why?) (fungibility of shares, allows the accumulation of bloc holdings), lowers the transaction costs directly blocholding- large investor that accumulates controlling portions of shares, large fractions of ownership control, ownership concentration. B&M-diffuse ownership is bad. 4. stock price reflects more information about the firm's true value (price depends only on the PV of the expected earnings stream) 5. managers are encouraged to undertake risk projects managers often have a lot of non-diversifiable personal wealth in the firm, without LL, would be very risk averse. limited liability is not the defining characteristic in almost any organizational form- they all have it to some degree.

derivative shareholder suits

shareholders bring litigation on behalf of the corporation A shareholder derivative suit is a lawsuit brought by a shareholder on behalf of a corporation against a third party. Often, the third party is an insider of the corporation, such as an executive officer or director. Shareholder derivative suits are unique because under traditional corporate law, management is responsible for bringing and defending the corporation against suit. Shareholder derivative suits permit a shareholder to initiate a suit when management has failed to do so. E&F note the lack of a link between how much stock is held and incentives to bring a suit, may result in perverse incentives to bring DSS perhaps they (along with attorneys) don't have the incentive to maximize the value of the firm however, directors have the ability to terminate DSS as one of their ordinary business judgments, but may not be impartial

fiduciary duties in closely held corporations

shareholders in closely held corporations join each other in the utmost duty of good faith and loyalty. requires controlling shareholders who base the positions to confer benefits on themselves to do the same for all investors.

closely held corporations

smaller number of participants in closely held corporations ensures that managers bear more of the costs of their actions and facilitates contractual agreements between the parties to reduce the likelihood of self dealing

competing ownership structures

so what is really competing is alternative ownership and contractual structures, each ownership structure has its own array of costs and benefits the open corporation ownership structure creates a unique set of costs and benefits

self enforcing contracts

some contracts are self enforcing recall the numerous mechanisms that help lower the agency costs some economics of contracts key issue is whether or not transaction is a repeat transaction, if not repeated (say house purchase) legal sanctions are important if repeated, (say purchase monthly fuel oil) legal sanctions are less important numerous market based mechanisms help agency costs.

background on state incorporation debate

state incorporation laws provide the legal framework that governs the contractual relations between shareholders and managers sets up standard contract terms: -fiduciary duties of managers to shareholders (duty of care and duty of loyalty); rules about what issues must be put to a shareholder vote, etc. -branch of the law of contracts; these are default rules that firm can alter (other type are mandatory rules) mandatory rules cannot be contracted over

takeover law

state laws generally allow for freedom of contract corporations can make firms either takeover proof or takeover prone delaware is generally permissive regarding the use of anti-takeover devices note distinction in law's view of FDs between ex post (before the bid) and ex ante once the bid is made, the burden of proof shifts to the managers to show behavior was in the shareholders interests. however, court is generally still deferential to managers, allows free contracting, (i.e. enabling) corporations compete on this margin as well can become more takeover proof or takeover prone: recall that all costs will be internalized in the stock price

shareholder voting

stockholders have the right to vote, bondholders (debt holders) don't shareholders usually vote for the board members, the accounting firm, also engage in "issue voting" issue voting (set out in charter) usually includes approval of certain major actions, such as: mergers, liquidations, major sale of assets, new charter amendments you can change the voting rights of your organization form as you see fit.

law as product view

suppose one firm relies on inferior protections for investors investors will rationally assess their risk in investing in that firm firm choosing poor protections must pay more for capital (i.e. will have a lower stock price) poor investor protections are a risk for investors, just like other risks firm will internalize the cost of choosing a state with poor protections managers in the firm will directly bear a higher cost of capital through lower pay or dismissal states also compete for revenue associated with firms incorporating here state competition is a "race to the top" NB: Delaware law can be "best" for some firms without being perfect both winter and cary see law as a product

leveraged buyouts

take out loans to help buyout a firm

Terrafuggia- non FAA approved

tell it where you want to go, it flies for you lands safely for you in seconds, an airplane becomes a car, door to door transportation vertical take off and vertical landing think of this as an investment think of yourself as a fiduciary what would the competition for this be like? is it a monopoly? what patents does this company have? what is the cost of producing these? upping them, and they need to make a profit? risk!! organizational form... project financing, raise debt against future revenues project- SPV- special purpose vehicle- a legal special purpose the project has its own legal entity project financing itself would have legal personhood you can take the assets of the SPV but the investors are protected. you would likely use debt and equity. hotels and movies are financed like this. some movies are terrible and some are great- you are an investor in the SPV of a movie.

closely held corporations

tend to have relatively few managers who are the largest residual claimants. because the firm's principal investors also manage it, it is often necessary to restrict the investors ability to alienate their shares. such restrictions increase the probability that those who manage will be compatible. when the same people both manage and bear the risk of investment, the firm loses the benefits of specialization. because those who manage must also put up capital and bear risk, the pool of qualified managers is smaller. investors in a largely held corporations have large percentages of their wealth tied up in one firm and lack access to capital markets, thus, they are less efficient risk bearers then investors in publicly held corporations who diversify a larger portion of their portfolios reduced agency problem 1. absence of a secondary market creates valuation of residual claims that is uncertain, no market price for shares, and because controls limit the number of buyers, even permitted transfers of shares will be made more difficult to transaction costs 2. conflicts over dividend policy and other distributions. 3. precludes reliance on public monitoring. cannot easily link pay to performance 4. deprives uninformed investors of the protection of purchasing at market price, price doesn't reflect available information about value there is less need for outsiders to monitor managers restrict the alienability of shares to ensure that those who are investors are also compatible as managers. concern for minority investors is that those in control will prefer themselves when distributing earnings. investors in close corporations often put a great deal of their wealth at stake and the lack of diversification compared with investors in publicly held firms induces them to care. involuntary dissolution requires a valuation of the business and a distribution of the proceeds to the complaining shareholder. OR, one or more of the other parties can buy out the other.

the business judgment rule (BJR)

the BJR is a legal doctrine that absolves managers from liability for bad results if they exercised proper business judgment law: has evolved over time in courts applies even if managers behaved negligently (i.e. carelessly) but in good faith (i.e. honestly) shields managers from the risks of bad decisions courts have evolve this rule overtime, as long as it was made in good faith. does the BJR make sense? it appears to contradict the duty of loyalty and care the court defers to the business judgment of the managers. you want the firm to take risks, you want the highest value of the firm, managers will be too risk averse without this. could be seen as a gift to managers. if managers did not have this, they would be far more risk averse, recall managerial risk preferences makes sense that managers are not too risk averse, you want a company that is working efficiently. link risk to residual claims, you want to maximize the value of the s&p 500, you want them to be as efficient as possible- this is socially efficient it is most efficient for firms to contract until the marginal cost of contracting equals the marginal benefit. efficient (in this case)= for the lowest cost. allocation of something into or out of activities creates efficiency. there is not a unit price per clause, however. also, may be other better mechanisms to incentivize managers than legal sanctions (self enforced contract) 1. legal and regulatory: civil, fines and imprisonment ex post- law comes in after a violation has been committed, regulatory compliance 2. market based: stock price- bond market/rating, if you mess up, the grade of your bonds can go down, product market, labor market ("career concerns"), activist investors- market for corporate control- teams of people, investors on behalf of corporations, trying to get control in order to make smart investments, activists are a subset of the market for corporate control that come from 1 share, 1 vote 2 works strongly on boards and senior management, margin of tradeoff for these two can step back in places where market based mechanisms are strong. law becomes very important in a transaction that is not repeated. why does the court defer- market based mechanisms

market liquidity

the ability to buy or sell a large security position quickly, cheaply, and without affecting the market price. large banks are involved through their roles as dealers, counter parties and intermediaries involved in trading a wide variety of assets, including futures, bonds, ST secured borrowing and lending. supervisors have increased the minimum amount of capital that banks must hold against their total assets via the supplemental leverage ratio to limit the increasing risk. SLR does not assign lower requirements to low risk assets which effectively implies a substantial income in the amount of capital banks must hold against the risks in the market making activity. market liquidity is a network good- money that liquidity begets liquidity as buyers and sellers gravitate to trading revenues and asset making where there are a lot of other buyers and sellers with whom to trade. as intermediation because more costly from a capital perspective, large banks are reducing their activities and market liquidity declines. buyers and sellers would then incur higher trading costs, experience longer lags in executing their trades and suffer the adverse effects of imperfect prices. large bank declines do seem to have stepped back from intermediaries but market liquidity in corporate bond markets does not seem to have decreased. other market participants may have already stepped in to provide liquidity and capacity, including hedge funds and high frequency trades. liquidity changes over time, sometimes very quickly. the rule of high quality collateral in financial markets and the impact of central bank asset purchases, on the availability and ease of that collateral in the open market.

institutional liquidity

the ability to meet short term financial obligations through access to funding markets or liquidating assets the function of banks is to transform ST deposits into long term loans and securities. this is risky because net deposit withdrawals may exceed loan repayments. in order to honor the deposit withdrawals, banks may be forced to sell assets at distress or fire sale prices, such sales not only result in banks taking losses on its assets, these sales also reduce the perceived value of similar loans on the sellers and the other bank's books banks have sought to reduce the risk of institutional illiquidity in the future by adopting new numerical minimum requirements. for banks to hold more high quality liquid assets in proportion to the instability of their fundings. comes at the expense of making other individuals and institutions less liquid. reduced liquidity for other means that central banks may be under greater pressure to lend to non bank firms in some future financial crisis. as banks are required to hold a larger percentage of assets with high market liquidity, the risk that they will face an institutional liquidity stress event, an ability to meet their ST obligations is lessened. but, there will still be demand by borrowers for long term loans and a demand by lenders for products that offer them ST access to their funds. as banks reduce their function as a liquidity transformation service, non banks will step in to fill in the void. mutual funds cannot fail, as whatever losses they incur are passed through to their shareholders the financial stability concern is that large and rapid investor redemptions access a large number of funds will trigger sales of assets with low market liquidity and drive large price declines that would transmit financial stress to other institutions.

1933/1934 SEC Acts

the argument is not that providing capital is bad, but that providing capital is good and must be protected if fraud is rampant, then investors (widows and orphans) will not provide capital and the system will not work the public interest depends on investors providing capital and lots of it strange story: fraud already unlawful in every state in 1933 every state except nevada had administration for enforcing fraud statutes when you see a federal regulation passes- (1) it is in the public interest and maximizes social welfare pie (2) actually, no, it is benefitting private interests, lobbying with gifts and interests to get a bigger slice of the existing pie, benefits are narrow, private interest. public interest explanation depends on providing capital and lots of it. also a private interest explanation for these regs: their goal is not to benefit the broader public interest but to benefit narrow private interests this of the costs of compliance as a fixed cost that must be incurred to issue regardless of the size of the firm may benefit larger issuers as well as investment banks this is an issue for many types of regulations large firms can spread that fixed cost out over more output, regs have the benefit of helping larger firms at the expense of small firms can view regs as a way of assisting and maintaining cartels regs also help law firms and investment banks (which can offer advice) rivals cannot compete by offering differentiated products rules may also benefit exchanges by facilitating cartels... hard to conclude based on the evidence

legal background

the best, most developed law for that type of corp (i.e. small vs. large) is likely to prevail focus on one big set of federal laws: Mandatory disclosure two main securities and exchange acts in 1933/34- regulate information not certain acts. height of the great depression, you need to fill out forms on a quarterly basis every year. verifying that this information is truthful you want criminal punishment because the probability of catching the fraud is low, you want to stack the punishment to something severe in order to disincentivize confidence in the markets- charge a higher risk premium if you don't trust the market, cost of capital, but society likes a low cost of capital for scale and scope reasons. want the fluidity in the markets. two main aspects of 1933/34 acts -prohibition against fraud -requirements for disclosure when securities are issued and periodically thereafter -federal law has been occasionally added to (e.g. the williams act, sarbanes oxley, Dodd frank act) Sarbanes Oxley- after corporate governance scandals of enRON, WORLDCOM, tyco, the boards are not actually paying attention to what he eco AND THE RESt of the team is doing. mandated that audit committees must be made up of outsiders. Dodd Frank and SOX represent a major federal intervention into corporate governance and SEA of 33/34, are just about disclosure the details of disclosure requirements have become very complex the investments themselves are relatively un-regulated basic principle is that investors can buy/sell as long as no fraud (rational maximizers) but there may be asymmetric information between the firm and investors note that the risky nature of the residual claims means that tho one can offer guarantees of performance Note that the SEC rules have survived while others repealed note link to standard rules of contracting: formation defenses in contracting incapacity, fraud or misrepresentation, duress, mistake, unconscionability

the board of directors

the board is the link between shareholders and managers stylized fact- shareholders are generally diffuse and managers are concentrated the board has a fiduciary duty to shareholders, just like the managers the board should monitor managers on behalf of shareholders board members are also the agents of stockholders

share buyback or share repurchase

the board makes the decision to buy shares back out of the market (usually at the market price) could signify faith in the company (price could go up)

doing good while doing well

the company can do good financially while also doing well for the environment, the community, etc.

legal personhood

the concept that allows corporations to be a party in a court of law

costs of limited liability

the externalization of risk outside the firm onto society (e.g. environmental pollution) true for all organizational types standard micro analysis of externalities applies (i.e. internalize via usual policy mechanisms) the externalization of risk inside the firm i.e. onto bondholders -pushing nervousness onto fixed income people also called risk shifting stockholders et all benefits of riskier projects, bear only a portion of the costs (creditors such as bondholders bear some of the risk via default)

Paula Tkac guest lecture

the federal reserve does not create the currency of the united states what does the future hold for the financial system? FLMC decided to lift interest rates off of 0% after being there for 7 years rely on businesses in respective districts to give information about the national picture once the cost gets large enough, you see more cash hoarding. shadow banking- systematically important financial institutions that are not banks a lot of them do not want to be considered systemically important because that means more regulation. engage in market making, trading, and investment banking services lending to small and medium size businesses shadow banks- are financial institutions/ intermediaries that conducts maturity, credit and liquidity transactions/ transformations without explicit access to banking shadow banking is about 40% of the financial system takeaway #1: it's big and its complicated, should we care? what does it take to be a non bank SIFI and in return your firm receives.. oversight by the fed potential liquidity, leverage and capital regulation takeaway #2: valuable yes? risky perhaps? takeaway #3: get comfortable with risk, think institutions and activities

fiduciary duties

the highest standard of procedural and substantive performance ever developed under our legal system

residual claimants

the individuals who hold property rights to the net cash flows of an organization property rights to any organization (and thus the firm itself, are defined by the nature of its residual claims. )

Berle and MeaNS "Separation of ownership and control"

the modern corporation and private property (1934) atomized ownership disbursed each owner will not invest in monitoring the managers, so managers end up running the firm in their own best interests free-riding- public goods problem monitoring is a public good everyone invests too little

common law

the part of English law that is derived from custom and judicial precedent rather than statutes. Often contrasted with statutory law. the body of English law as adopted and modified separately by the different states of the US and by the federal government. denoting a partner in a marriage by common law (which recognized unions created by mutual agreement and public behavior), not by a civil or ecclesiastical ceremony. law established by court decisions rather than statutes determined by legislature

A corporation's residual claims

the residual claims (RCs) of the corporation have a unique attribute the residual claim, or property right to the net cash flow, is fully alienable, tradable, or transferable (and hence "open" tradable and divisible (Stock split)- ownership shares are these two things this is the unique aspect of the corporate form and this key attribute has important implications

civil law

the system of law concerned with private relations between members of a community rather than criminal, military, or religious affairs. the system of law predominant on the European continent and of which a form is in force in Louisiana, historically influenced by the codes of ancient Rome.

non-profit (ex. cornell, museum)

there are no residual claimants, no one can assert a claim to the revenue costs no group that can asset a legally binding claim to the individual

franchise

these are chains, the RC's- the franchisees, royalties to franchises

firm

think broadly of any structure through which people organize themselves into groups or teams to accomplish some purpose. 2. key aspects to categorizing firm types: 1. structure of the property rights (i.e. ownership) in the firm 2. details of contractual arrangements -can view the firm as a nexus of contracts note the links to areas of law: property rights and contracts are first two basic areas of the common law (third area is torts) focus on the details of property rights in defining the firm

the economics of corporate control

think of corporate control transactions like any market transaction if one person buys oranges from another, buyer must value them more highly than the seller can also think in terms of an auction: competing management teams bid for control of corporate assets price is still an allocative mechanism (stock price) consider both static and dynamic efficiency of corporate control transactions is this reflected in the price? if you bought XYZ corp this week do you want it to be taken over next week? but in the corp, must also consider the effect of transactions on agency costs contracting costs are another reason the firm's boundaries may change (i.e. non-agency cost reasons) for example- if the cost of contracting with a supplier rises, the firm may buy the supplier

outcomes of state incorporation

this does not imply that state laws always generate efficient outcomes role of large (e.g. institutional investors) in overcoming the rational ignorance of small shareholders, large shareholders will drive the search for the best set of rules sorting and matching- states and firms will sort/match based on specialization state competition also means that firms can choose the state that best meets their needs (e.g. reduces transaction costs) this implies that not all firms will incorporate there (DE) posner and scott argue that delaware is most appealing to large firms (CA has more incorporations, but firms not as large) argue that the benefits to specialization of management vs. risk-bearing are the greatest there State competition can also produce innovation in corporate law ("laboratory of the states" states may mimic the rules of others, note the S-curve)

where does a company have a competitive advantage

to have 1-2 competitive advantages is amazing durable and can't be replicated easily.

10b of the securities exchange act and SEC's Rule 10b-5

to require corporate insiders and their tippers either to disclose material information or to abstain from trading. insiders may either disclose then on public information and then trade or keep silent and refrain from trading. the disclosure of abstain rule applies only if a defendant trades on the basis of material inside information- BIG NEWS when disclosure is possible and not harmful to the firm, the release of news to an efficient capital market eliminates gains from trading. when the news is less dramatic- insiders remain free to trade on the knowledge, they do so an earn rates of return that are on average slightly in excess of the market as a whole. reporting of insider trading allows investors to make accurate inferences about insiders compensation. will give future managers info about compensation. there is a prohibition against short selling trading in many cases.

corporate governance

to try to solve the agency problem, series of institutions which can help put in place to solve the principal/agent problem in the corporation.

insider trading

trading by parties who are better informed then their opposite members, no market could exist with such a broad definition of prohibited trading, if each trade has the same information as every other, there is little incentive to trade. the incentive to acquire information in the first place goes down if the opportunity to profit by virtue of superior information is eliminated. if there is no incentive to acquire information, markets lose their function of providing price signals to diverse participants in the economic. trading by those with unequal access to information? managers are said to have unequal access to information- is appropriate to trade if they own that information. may get the right by hard work or generate it themselves or buy it from the firm. OR traders may steal news from others who create or own the information if the firm discloses no info, outsiders may assume the worst and discount the price they are willing to pay for shares by a factor that reflects their uncertainty. better managers signal their quality by willingness to tie a higher proportion of their compensation to stock performance. accurate prices then enable these managers to receive the awards of superior performance. complete disclosure would not make sense. disclosure is costly and at the same point, the costs exceed the benefits of increased disclosure, disclosure might destroy the information's value. info about prices for future products or acquisitions is less valuable if released. investors would like the price of the stock to reflect this information without the information coming out, if managers trade on the price of the tock, moves closer to what is would have been if the information had been disclosed. insider trading allows a manager to alter his compensation package in light of new knowledge surrounding continual renegotiation. pushes managers to produce valuable information BUT bad news is easier to create and you can trade on this as well disseminated false info about the firm so they can profit by buying and selling mispriced securities managers trading is said to be unfair because managers receive the gains in lieu of the shareholders who deserve them, but is it unfair to investors to use a device the makes them weathier?

commentators on the laws of england

treatise on the law, encyclopedia documentation on what the law is, analyzing its structure and trying to make sense out of its structure common law 1. law of the commoners as opposed to the royals (comes out of unintentionally injuring someone) 2. law of property, contracts, torts criminal law/civil law- comes out of purposeful wrongdoing 3. bottom up common law- bubble up from decisions made at the state court level, judge made law as opposed to legislative made statutory law/civil law- codified law, top down law, roman law justice comes from this. napoleponic codes 1804 common law- largely regarded as leading work on development of the english law. the rights of persons, things, or private wrongs, of public wrongs. legal identity of woman was pushed into that of the husband. husband owned land on behalf of women, would sue on behalf of the wife. F.A. Hayek- austrian economist, strong statement about the efficiency of the common law, legal origins debate derivative suit- permit shareholders to bring an action in the name of the corporation against parties allegedly causing harm to the corporation any proceeds of a successful action are awarded to the corporation and not the individual shareholders that initiate the action. this board can dismiss the suit against itself. appraisal arbitrage. on derivative suits- lack of a link between how much stake is had and incentives to bring a suit, may result in perverse incentives to bring DSS

activist investors

tries to change and right the companies they invest in.

mandatory disclosure

unless people who offer the better securities, representing claims in superior combination, can distinguish themselves from others, investors will view all securities as average. higher quality securities will sell at prices lower than they would if information were available cost-lessly, and there will be too little investment in good ventures. low quality securities will attract too much money, cheap to offer a low quality security (over compensated) high quality sellers must take additional steps to convince investors of their quality, firms may sell their securities through investment banks who respect the firm's prospects. the penalty for fraud makes it more costly for low quality firms to mimic high quality firms by making false disclosures, an anti fraud rule imposes low or no costs on the honest, high quality firm. thus, it makes it possible for high quality firms to offer warranties at lower costs. the expenses of offering high quality securities goes down. mandatory disclosure system substantially limits a firm's ability to stay silent. and, controls the time, manner and place of disclosure. public interest explanation- markets produce too little info about securities when the only rule is against fraud, if the producer of the info cannot obtain all of its value, too little of the info will be produced. if disclosure is worth more to investors, firm can gain by producing it. must disclose the bad with the good or investors will assume the bad is even worse. (do this through third parties) information produced by one firm for its investors may be valuable to other firms and their investors. because investors in other firms cannot be charged, info will be underproduced. lesser the degree of difference between firms, the more spillover the disclosures of one firm will have and the poorer the firm's incentive to disclose will be exchanges have an incentive to adopt rules that require listed firms to disclose the amount and type of info that investors demand. firms, in exchange, have incentives to list their securities on exchanges that maximize investors wealth. disclosure rules both deter fraud and equalize access to info, reinstating necessary confidence in investors. "unsophisticated investors need special protection"- disregards price efficiency increasing the supply of costly information. standardized, routinized disclosure- imposition of a standard form of disclosure facilitates comparative use of what is disclosed and helps to create an efficient disclosure language.

unlimited liability

unlimited liability- as an investor, you would be driven to the opposite of diversification "performance"- accounting measures, stock market, performance (level of change) if there is unlimited liability- managers will be very risk averse

takeover ease

very hard to takeover corporations because management makes off with the assets if it is spread in, it is not an externality

wall street rule

vote with managers or sell your shares, this is anti activist investor

organizational forms

we can categorize organizational forms (i.e. firms) through i. the nature of their residual claims ii. details of contractual agreements the unique characteristic of the corporation is the freely tradable (or transferable) nature of the residual claims the costs and benefits of the corporate form stem from the tradability

the corporation as a dynamic mechanism

we have thought of the corporation as essentially unchanging across time in reality, the corporation is dynamic, almost constantly changing in particular, the boundaries of the firm are frequently changing in law, the corporation is a legal person, like an individual better to think of the corporation as an economist would: as an equilibrating mechanism" a market is one example of an equilibrating mechanism (maximizing total surplus think of the corporate as always headed toward an equilibrium, maximizing shareholder value boundaries and structure of the firm can change in response to the costs and benefits of that change how can the corporation change form? mergers (bidder and target firm negotiate) tender offers ("friendly" vs. "hostile") proxy contest leveraged buyouts going private transactions share repurchases or share buybacks typically the bidder is bigger than the target. hostile= management of the target is against takeover. they will fight the tender offer. friendly= incumbent management of target welcomes takeover managers have many choices about altering the firm structure subject only to the fiduciary standard structure is left up to voluntary contracting (BJR applies) think of a continuum along a public/private dimension managers can alter the "public-ness" of corporation through a variety of transactions recall the continuum of "openness": can now include corporate control transactions note the role of a premium in corporate control transactions benefits of going public- risk spreading and raising capital, but you can create more agency problems the less public you are, the fewer the agency problems there are. if these benefits diminish in value, then it makes sense to de-corporative the firm state law is typically enabling-courts will defer that many things are business decisions by the BJR

role of the board

what are the board's duties? what does "monitor management on behalf of stockholders" mean in terms of actions -decide on what is good performance -set performance goals for management -review major corporate plans and objectives -replace managers when performance is poor -make recommendations to stockholders on voting issues -decide on what info it wants to obtain from managers board SHOULD NOT be involved in day to day firm operations board SHOULD NOT second guess managers (why?)- it demoralizes them

the firm's decision to hold a vote

what are the costs and benefits to the firm of using the voting mechanism? could indirectly vote against the firm's best interests- you are eliciting preferences you have rationally ignorant shareholders- the quality of information you are likely to get could be poor benefits: what is the quality of the information contained in a vote about shareholder preferences? compare to info received via changes in stock price, or info sent by the product market itself? the info about your stock price and product market is more valuable you don't want to do it too often but you want to do it some, you would not want to be a shareholder in a firm that never allowed voting. voting used (only) when its potential benefits are high, control of agency costs. issue cases often takes place in cases where agency costs are high. costs to firm? voting used (only) when its potential benefits are high (control of agency costs) issue voting often takes place in cases where agency costs may be high fundamental corporate changes charter amendments

the economics of voting

what are the costs and benefits to the shareholder of voting? costs to the shareholder? time it takes to familiarize yourself and decide who to vote for (information costs) read up on the firm. you need to know who the board of directors is benefits to the shareholder? medium to express your interests and opinions about the company. hopefully eliminate some of the agency costs. but, unlikely that you are going to be the marginally powerful voter. rationally ignorant voter- quality of decision that voters are likely to make is perhaps poor. benefits to voting are near 0, costs are high consider a rationally ignorant voter- one form of a collective action problem will voters make good decisions? what mechanism is available to shareholders to address rational ignorance? but not political voters? you can go and buy more shares and thus have more votes. you don't want atomized investors, you want big investors, helps to solve the collective action problem

suppliers

whether suppliers have a stake in the firm depends on whether they have made substantial investments in durable assets that could not be redeployed without sacrificing productive value if the relationship with the firm were to be terminated permanently. suppliers who make substantial firm specific investments in support of an exchange will demand either a price premium or special governance safeguards. membership on the board should be restricted to informational participation.

the firm as a mechanism to reduce transaction costs

why firms exist first addressed by Ronald Coase, "the nature of the firm" Economica 1937 Coase noted that much resource allocation takes place within firms instead of through markets Note that Oliver Williamson "hierarchies" (see the economic institutions of capitalism) must be some benefit from allocating resources within a firm rather than through a market? what are those benefitS? coase's answeR: firms exist to conserve on transaction costs

economics of insider trading enforcement

why is public enforcement of insider trading necessary? -going to jail -public perceptions of the crime as a deterrent repetitional effect- huge market impact, bad for the business what matters is the expected punishment- probability that you are caught (X), they penalty if you are caught deterrent depends on that probability of being caught is very low because it is very difficult to trace information although there is an algorithm to red flags on trading one way to increase the expected punishment is to increase the penalty with criminal enforcement, as opposed to just civil cases where people sue one another for money if you can get the criminal liability as established, civil cases will follow why not simply specify monetary damages in contracts

shareholder voting and risk bearing

why is voting structured in this way? why is voting link to bearing residual risk through stockholders? -decision control with risk bearing reality, creates another agency relationship if they are separate. why one share, one vote? 10 shares, 10 times the amount of voting power, you can accumulate voting power by buying up shares. you are bearing more risk so you get more votes. why no vote-buying/selling separate from the residual claim?

Chiarella

worked at the printing office, name of the target was in cost, time and dates, he cracks the code and finds out what the name of the target was, and then he trade on the information was this hard work? and therefore he is entitled to property right definition or, working hard to steal something? finding was that he was not guilty, because he had no fiduciary relationship to the firm.

DNO insurance

would not join a board without this, he joins board only if he can make all of the meetings, demands a meeting with the CEO, there have not been a lot of cases where board members are fined or need to pay a lot of money. technology can be a very significant source of value creation.

production function

y= f(L,l,K), land labor and capital (money, materials, machines) y is the output- the supply side of the market. think of the investors in the corporation as allocators of capital- land labor and capital move into one industry and out of another.

Yahoo's activist investor is makinf a bid to remove the company's entire board

yahoo's dismal financial performance, poor management execution, egregious compensation and hiring practices complaining of agency costs starboard- 1.7% of yahoo's shares, 570 million dollars getting hostile target adds board members in advance of the proxy fight staggered directors terms- you can't elect the whole board at once. becomes hard for a bidder to get control of the board. a lot of activist investor companies have reputations and these reputations are very important.

formation defenses in contract

you cannot bind certain things into a contract children, insane people, you can do a drunk person, not lied to