week1 - Corporate Governance Course Introduction Thomas Noe...

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Unformatted text preview: Corporate Governance Course Introduction Thomas Noe The circles of governance CEO comp board creditors/ shareholders accounting system law/culture The circles of governance Law: Legal system and culture (e.g., common law vs. civil law) Accounting System Activism by outside owners Creditors (bankruptcy, debt restructuring) Outside equity (takeover, relationship investors) The Board: compensation, replacement .... Perspectives for viewing the circles Principle-agent theory Transactions costs Neo-classical economic theory Incomplete contracting Governance Questions Does governance affect value? If it does, which aspects of governance are most important? Can financiers profit from trading on or intervening in the governance process? Approach Peel back the circles of governance Starting at the macro level of legal institutions and ending at the micro level of CEO compensation and replacement I nstructional M aterial Lectures---develop the basic concepts and outline theories. Clinical Studies---analyzing a specific governance issues affecting a single firm Empirical Studies---large-scale studies of a given issue in governance. Provide validation for theory In Class Simulations---experiments simulating the incentive conflicts faced in governance conflicts. Learning experience Breath course as opposed to depth Most issues current Significant reading requirement Large number of disparate and conflicting points of view Organizational Structure Thomas Noe Organizational Structure Thomas Noe Lecture Objectives Students should Understand how the organization of corporate activities can affect value How institutions affect value: How do institutions affect value? Neoclassical economic theory Economies of scale/ Economies of scope Principal- agent theory Optimal contract design Property-rights theory Transaction Costs Incomplete contracts Minimize transaction cost of economc activity Transactions Costs Example: choose corprate form to minimize legal/tax costs taxman taxman investors Organizational forms investors Taxes/transaction costs Tax/transaction cost approach Important insight---taxes must be considered in designing organizational form. Important limitation---can only completely explain a small range institutional designs Examples of Tax Motivated Organizational Features: ``Stapled'' and paper-clip REITs, MLP in the energy industry. Neo-classical theory Neo-classical theory-- Firm as a collection of production plans Manager presides over production set Manager acts to maximize wealth of owners by maximizing the market value of the firm. Maximizing flow of relevant information to decision makers facilitates optimization Example: Explains why the foreman at the factory reports to the plant manager and not to the public relations department? Neoclassical theory Neoclassical theory (cont.) Insights from neo-classical theory Production technology is important Creation of value is ultimate objective of firms Limitations of classical analysis Cannot explain the boundaries between firms or the boundaries between firms and markets Example: Does not explain why firms, when they combine their operations, change the compensation packages for managers. Principal-agent theory Principal-agent theory Firm is a production set Managed by a professional manager acting in his own interest Managers relationship investors, workers, customers, and other firms is governed by contracts Contracts can be written on all observable variables. The flaw that prevents attainment of neoclassical bliss: nonobservability Principal-agent theory Principle-agent theory (cont.) Nonobservability Managers and workers have hidden information about The state of the world (asymmetric information) Their own actions (moral hazard). Principal-agent theory Why is nonobservability important Contracts cannot be written directly on the inputs provided by agents. Instead they have to be written on the observable output of agents actions. This leads to distortion of decisions and reduced firm profits. Principal-agent theory Example: Y ou decide to hire a salesperson to sell widgets for your company Sales of widgets = f(salesperson' s effort, luck) You are risk neutral, your salesman is risk averse. Optimal contract. Pay your salesman based on his effort. You shoulder risk. Principal-agent theory Problem: Y ou can't observe salesperson's efforts. So you have to pay based on output If you make the salesperson's pay very sensitive to output then Salesperson must bear substantial bad-luck risk. Since he is risk averse, this will greatly increase the amount you have to pay him/her. If you make his/her pay insensitive to output Salesman will require less compensation but not work very hard. Principal-agent theory Example (cont.) So, because effort is nonobservable output will be lower and/or risk bone by salesperson (and thus his compensation) will increase These costs will be passed on to you (the owner) Bottom line: The firm's profits will be lower because of nonobservability of the salesman's actions. Principle-agent theory Principle-agent view: summary Firm is a production plan Some of the inputs to the process are not observable The output of the firm should be divided between the factors of production based on observable variables in a way that minimizes the distortions caused by nonobservability. Principle-agent theory Principle-agent theory: summary (cont.) The more "luck" in the production process the more the distortion. Distortion leads to lowered output from the managers (thus losses to the firm), or Higher compensation to managers (and thus losses to the firm) Theory does not explain why salesmen are hired by the firm rather than the salesmen recruiting a firm for which they sell. Property-rights theory Property-rights theory Basic premise---contracts are incomplete: it is only possible to contract over a tiny subset of all observable events. Property-rights theory Why are contracts incomplete? Inalienability of human capital. You can't enforce contracts for personal service. Nonverifability: E.g., even if both a worker and his boss know whether he has performed a good job it may be impossible to verify this fact to a third party (court). Unforeseen contingencies. It is expensive to specify contractually every contingency. The costs may far exceed the benefits. Property-rights theory Because the scope of contracts is limited-- (most) economic value is divided up by ex post bargaining not by ex ante contracts. Bargaining power depends on property rights Thus property rights are paramount Property rights: The the right to make all decisions relating to an asset not specified by law or contract. Property rights theory Allocation of property rights affects Allocation of economic profits Different property rights allocations imply different threat points in the negotiations that determine output decisions. Efficiency of economic activity The allocation of profits affects the willingness of economic agents to invest their time and money in projects. Property-rights theory An example from the turn of the last century: GM and Fisher Body (as told by Klein et al. (1991). GM (born in 1908) and Fisher Body (born 1908) started of as separate firms. Fisher manufactured bodies for GM cars The costs of GM switching to another source for car bodies or Fisher switching to finding another customer for its car bodies were prohibitive. Property-rights theory Before 1926, GM and Fisher were separate companies; relationship regulated by contracts. Potential holdup problem: Suppose due to an unforeseen engineering breakthrough by GM, the demand for GM cars rises GM want Fisher to provide more bodies than called for in contract. Contract does not specify price for extra bodies. Property-rights theory What price will GM have to pay for Fisher car bodies? Situation I: Fisher and GM separate companies: Status Quo point in negotiations: Fisher mgt. and GM mgt. cannot reach an agreement GM losses orders Fisher does not provide bodies Property-rights theory Situation I: Fisher and GM separate companies (cont.) Fisher management should be able to capture a significant fraction of the total gains (to both firms) from moving from the status quo point and producing the extra bodies. Thus, Fisher can "hold up" GM for a fraction of the gains from GMs innovative engineering. Property-rights theory Situation II: Fisher owned by GM. Status Quo point in negotiations: Fisher mgt. and GM mgt. cannot reach an agreement GM uses Fisher plant and labor to build extra bodies using new managers. Fisher mgt. looks for alternative employment. By threatening to withhold its own services, Fisher management can only capture a fraction of the gains it obtained threatening to withhold Fisher's plant and skilled labor. Property-rights theory In both Situation I and Situation II, the extra car's will be produced. However, In Situation II, GM management will capture a much larger share of the profits from the extra cars. Property-rights theory Why does the fraction of profits captured by GM matter? In Situation I, GM management knowing that it is subject to "hold-up" by Fisher in the event of unexpected increases in demand will be less willing to invest in R&D and excess capacity Thus, the hold-up problem causes an underinvestment problem for GM Property-rights theory How can GM solve its underinvestment problem? According to Klein et al., the hold-up was solved by acquiring Fisher Body! (which occurred in 1926) The gains from reducing the underinvestment problem at GM can be split between GM and Fisher shareholders. (But Coase in a recent article (2006) article argues any potential hold up problem had already been solved by in this case by joint ownership, cross employment, etc.) M oral of the story: changing the organizational form, changes property rights, and this changes incentives. Property-rights theory An example from the turn of the this century: Disney and Pixar Disney (born in 1923) and Pixar (born 1986) are separate entertainment firms. Currently Disney is the most effective distributor of animated films Pixar produces the most valuable animated film Economic logic dictates Disney distribution of Pixar content. Property-rights theory Before 2006, Pixar, Disney were separate companies; relationship regulated by contracts. Problems Not possible to for Disney to simply buy content from Pixar Film quality is not verifiable Hard-to-quantify changes in Disney marketing strategy can affect value of Pixar future releases Property-rights theory Problems (cont.) Not possible to for Pixar to simply buy distribution from Disney Distribution efforts impossible to verify Hard-to-quantify changes in Disney marketing strategy can affect value of Pixar brand reputation Property-rights theory The contractual solution (reached in 1997 after Toy Story ) 10-year, 5-picture deal 50/50 split of production costs and profits Disney alone retains rights to the films and characters. Disney collects 10 to 15 percent of each film's revenue as a distribution fee. Property-rights theory Evaluation of Agreement By splitting costs and profits, contract provides effort incentives for both parties than simple contracts Does not resolve other hard-to-contract conflicts of interest. Unverifiablity: Effect of distribution strategy on band values of Disney and Pixar. Effect of Pixar's films on the value of Disney's own animated film products. Unforeseen contingencies. Is Toy Story II a "picture" under the contract def. Started as a straight-to-DVD then switched to theatrical release. Property-rights theory Moving from contracting to organizational change: The merger proposal (Jan 26, 2006) $7.4 billion buyout of Pixar by Disney Pixar CEO (Jobs) becomes largest Disney shareholder (6%) and seat on board of "Disney Pixar" John Lasseter, Pixar VP, becomes Chief Creative Officer with "green light" authority over all Disney Pixar productions. Pixar's primary directors and creative executives must join Pixar Disney Can the agreement resolve the issues not resolved by contracting? Summary Organizational form and value creation From perspective of tax theory Organizational form is designed to Minimize total tax liability of owners Stress: design of legal form From the perspective of neo-classical economics Organizational form is designed to Implement efficient production plans Stress: design of divisions/subsidiaries Summary From the perspective of principal/agent theory Organizational form is chosen to minimize the costs of associated with moral hazard and private information caused by nonobservability. Stress: contract design From the perspective of property rights theory organizational form is chosen to minimize the costs associated with incomplete contracts and opportunism. Stress: design of ownership rights Law, Culture and Finance Corporate Governance and Restructuring I ntroduction Road map Classical finance theory---perfect systems of contract enforcement Reality---imperfect enforcement of contracts. The degree to which contracts can be relied upon depends on the legal system and corporate culture. Consequences Consequences of differences in contract enforceability First-order effects---differences in transactions costs Second-order effects---differences in the behavior of corporate insiders Third-order effects---differences in the ability of firms to attract outside capital at affordable rates. Fourth-order effects--development of secondary markets for securities, role of family businesses. Classical Finance Theory Legal system perfectly enforces all contracts dividing cash flows between claimants All operating decisions that effect claim value can be costlessly contracted at the time claims are issued. Financial markets are competitive: investors will never be forced to pay more for a claim than what the claim is worth. Classical Financing M achine BASI C ASSUM PTI ONS Competitive capital markets: $$ new inv. = value of new inv claim. Value claims issued to new owners New investors Current Owners $$ The firm's operations, real invest. Operating policy contracted at the time claims are issued $$$$$ $$ claims held by current owners no leakage to third parties: e.g, lawyers Real Financial M arkets Enforcement of rights of claimholders is both costly and imperfect and varies with the legal system Shareholder rights: Examples proxy voting/vote by mail? preemptive rights? call ESM? Shares "blocked" before meeting? Minority shareholders can sue for "oppression" in court? Real Financial M arkets Creditor rights: Examples trustee or old management runs firm in bnk.? Can creditors block reorganization petition? Who has first claim on bankrupt firm: state, workers, or creditors? Efficiency of enforcement Examples: Rule of law Corruption Efficiency of judicial system What accounts for the differences? Legal Traditions Common Law (British Company Act) Examples: India, U. S., Israel, New Zealand Civil Law French Civil Law (Napoleonic Code, 1804) Examples: Portugal, Mexico ... German Civil Law (Bismarck's code of 1896) Examples: Germany, Japan, Austria, Korea Scandinavian Civil Law Examples: Finland, Sweden. Legal traditions English Common Law Origin: Molded by by Parliament and the aristocracy to limit the power of the sovereign. Philosophy: protection of individual property rights Development: Gradual evolution, evolving from decision to decision by precedent (stare decisis) Role of judge: resolve question of law, provide guidance to how to resolve similar disputes handled in future. Legal traditions English Common Law (cont.) Civil standard of proof: Preponderance of evidence. Procedure Less formal frequent use of juries uninterrupted hearing of case adversary system Corporate Governance: Duties of a firm's managers and board of directors to investors are created by case law as well as statutes. A broad fiduciary duty of the manager to the firm. Legal traditions Civil Law Origin: Based on the Corpus Juris Civilis of Justininan (527-565 AD) Philosophy: a just solution emphasizing collective over individual rights. Development: overarching statutory framework for all legal decision making with judges filling in the lacunae Role of judge: determine the facts of the case and and apply statues. Legal Traditions Civil Law Statutory law based originally on the Corpus Juris Civilis which replaced traditional roman law (case based and rather unstable) under Justinian (527-565) Basic aim was to construct an overarching statutory framework for all legal decision making with judges filling in the lacunae After French Revolution, Napoleon further restricted judicial discretion. Placed the state above the courts; relegate judges to minor, bureaucratic role Eliminates role of precedent (in theory) Civil law used to build state power Legal traditions Civil Law (cont.) Civil standard of proof: judge must be convinced beyond a reasonable doubt that the alleged facts are true and covered by statute. Procedure more formal no jury step-by-step sessions where the judge learns the facts and arguments of the parties judge takes the active role: questioning witnesses and formulating the issues . Corporate Governance: Duties of a firm's managers and board of directors to investors specified narrowly by statute. Legal traditions Types of Civil Law French Civil Law Napoleonic Code Explicitly place the state above the courts; Relegated judges to minor, bureaucratic role Eliminates the all scope for precedent (in theory) Explicit statement of the role of civil law to build state power German (Bismarck Code (1896) and Scandinavian Civil Law Closer to the original Roman framework. Leaves role for judicial precedent and decision making to "fill in the blanks" Bismarck Code also places emphasis on law and nation building. Differences in Legal Systems Differences in Legal Traditions Protection of shareholder rights low high French civil law German/ Scandinavia n civil law Common law Differences in Legal Systems Differences in Legal Traditions low high Protection of creditor rights French civil law Common (U.S.) law German/ Scandinavia n civil law Legal System Theory Effects of law on capital markets and economic development First-order effects: direct costs of the legal system vary across systems Lower enforcement costs reduce transactions costs of economic activity. Second-order effects: Corporate insiders will consider protection of minority shareholders and creditors when they determine dividend policy deal with other insider-controlled companies Determine CEO/insider compensation Weak protection will lower the value of outsiders' holdings. Second Order Effects Second order effects (cont.) The protection of creditor rights will affect the willingness of insiders to petition the courts for reorganizations honor debt covenants convey assets through dividend payments, self-dealing increase risk of operations to lower debt value. Weak protections will lower the value of debt contracts held by outsiders. Third-order effects Third-order effects: If protection of outside shareholders is weak:: Issuing outside equity will become more difficult and costly If creditor protection is weak Issuing outside debt will become more difficult. Fourth-order effects Fourth-order effects If outside equity financing is difficult/expensive, firms will issue little outside equity. Therefore: Secondary markets for equity will not develop Financing from family members will become more important. If outside debt financing is expensive Secondary debt markets will not develop Corporations will attempt to rely on debt financing adjudicated by foreign legal systems. Evidence: Shareholder Rgts. SHAREHOLDER RIGHTS: Test of Means (T-Stats) 1S/1V Mail NoBlock Common vs. civil law -0.72 3.03 4.97 English vs. French origin -0.87 2.82 3.87 English origin vs. L.America -1.57 3.29 2.00 Rest of French origin vs. Latin America -1.39 1.00 -0.74 CV/PR 0.15 -0.05 -0.85 -1.39 %Meeting Preempt 1.48 -2.53 -3.56 -1.71 -.91 -1.08 -1.67 -1.29 Opp 5.59 5.45 3.44 -1.39 Overall 5.00 4.73 2.98 -1.11 Common and Civil Law countries really offer different degrees of protection to outside investors. Evidence: Creditor rights PANEL B: TESTS OF MEANS (T-STATISTICS) Rest No Sec Mgt Overall Reorg AutoStay First Common vs. civil, law 1.86 2.65 1.04 4.13 3.61 English vs. French origin 1.89 3.06 1.75 3.55 3.61 English origin vs. Latin America 1.71 3.25 2.04 2.83 3.42 Rest of French origin vs. Latin America 0.33 1.14 0.77 0.11 0.90 Common and civil law countries offer different degrees of creditor protection Evidence: EFFECTS Regression Results (significant results in blue) Dependent Variables OWN. EXTERNAL CONC. CAP/GNP GDP Growth Log GNP -0.0312 Rule of law Anti-dir. rights 1 share/1 vote Cred. rights -0.015l -0.0385 0.0044 --0.0456 0. 1244 0.1433 4.8174 6.0688 0.4189 0.2824 0.5761 0.0226 0.0615 ----0.0205 -4.7687 0.1814 0.0667 -0.0124 0.0604 FIRMS /POP IPOS/ POP DEBT /GNP 1.3926 0.1433 0.0311 External ---finance is more developed in 0.0518 ------common law countries Legal systems the whole story? Legal systems theory does a good job of explaining the crosssectional differences in the development of external capital markets. The legal systems theory does not explain the evolution of external financing over time as well. Sample selection bias: counties were not assigned civil vs common law systems randomly, selection could be correlated with unobservable variables related to economic performance. Legal systems the whole story? Example: Germany vs. UK (1900-1914) UK Foss vs Harbottle (1843) effectively stripped minority shareholders in UK of investor Germany Minority shareholder could and did sue insiders Banks voted for outsiders by proxy Outsider supervisory board mandatory protection Inside directors could even limit the ability of outsiders to sue them for dereliction. No right to vote by proxy No prospectus required for a stock to trade Legal systems the whole story? Example: Germany vs. UK (Franks, Myers, Rossi) (cont.) Legal systems theory argues for Germany developing larger and more efficient external credit markets than UK In fact, both UK and Germany developed active external equity markets in the 1900-1929 period subsequent changes in regulation had little effect in either case on the diffusion of outside ownership stakes Legal systems the whole story? How did early UK and German equity markets protect outside shareholders UK: Trust based on proximity between insiders/outsiders Local investors and local exchanges predominated Insiders and outsiders part of the same social milieu Outside investors frequently active in same industry Germany: Insider's need to maintain a reputation with banks Banks represented outside investor by voting their proxies At the same time, banks controlled the equity issuance process and thus firms' access to external capital I ntra-national Legal System Differences Delaware and U.S. Corporate Law The unique status of Delaware More than 50%of all public firms are incorporated in Delaware (NY next with 5%) The Delaware difference the only state with a specialized Chancery Court for resolving corporate law disputes Broad development or court precedents Reputation for predictable decisions Incorporation fees about 20% of state revenues I ntra-national differences Does Delaware incorporation matter Why it might not matter Corporate law caters to mgrs who don't care about firm value Corporate law does not matter, contacts can undo effects of law. I ntra national differences Does Delaware Incorporation make a difference? Daines (2003) Examines the market valuation of 4,481 exchange-traded firms between 1981 and 1996 firms subject to Delaware corporate law are worth significantly more than firms incorporated elsewhere. Delaware firms are also significantly more likely to receive takeover bids and to be acquired. I ntra-national differences Why the Delaware premium? Delaware's unique political political economy Revenues from incorporation are a significant source of state income. Major corporate operations are not a significant source of state income. Should all firms incorporate in Delaware Not necessarily Is Delaware better than federal incorporation Not necessarily ...
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week1 - Corporate Governance Course Introduction Thomas Noe...

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