Share Ownership Dispersion & Board Governance: Coordination & Independence, Schemi e mappe concettuali di Corporate Governance

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CORPORATE GOVERNANCE Grade 50 % class participation 50% in class exam, on the last day of class During the last classes → present a paper in group, as if you wrote it Talking class → stick to the same place every class Reading of about 25-30 pages from a class to another → deeply understand the meaning, select important concept from irrelevant concept in order to be able to discuss it in class Presentation 12 November 20-25 minutes presentation (the professor decides the order of speaking) Prepare slides for the presentation and send them to the professor Prepare another paper as a class discussant, to challenge another group − stop and ask questions during the presentation or − at the end 4 or 5 minutes to criticize Write one/two pages with bullet points about the criticism of the paper and send it to the professor Firm: economic concept Corporation: legal entity that can undertake obligations Sum of activities Organization of goods and services made by people that want to reach some goals → stressing the components To complete the definition of firm we need to achieve a goal. Agent that provides goods and services for profit → stressing the output Organization that wants to create and share value with shareholders and stakeholders Intangible assets included, as knowledge Aims 1. Undefined 2. Profit 3. Value (associated to shareholders or stakeholders) Who Agent Organization ➔ people / goods and services / assets Activities Create to distribute 1850 Alfred Marshall Definition of a firm in microeconomics: firm is something that maximize profit at certain price for the quantity of good or service consumed. Max profit = P x Q – w x L – r x K The maximization is subject to a constraint, the production function which tells us how you can obtain the quantity of a product combining labor and capital Q = f (L, K) perfect allocation to maximize Q. In a competitive market the firm is a price taker, so P, w and r are given. Will, interest and desire in economics are always related to people, not to organization. A company is not an agent, so it has no interest. ➔ Firm (agent) as a black box (production function) to be optimized to produce profit 1950 Baumol Tendency for CEOs to do the empire building (a lot of mergers and acquisitions), due to the pursuing of his personal interest. From 1960/70s new view of the firm → Alchian & Demsetz, Jensen & Meckling Nexus of contracts among different agents with interests to pursue Employees – Tom management – Board of directors Shareholders (providing capital) – Bondholders → subjects who don’t live the firm’s life daily External suppliers – Customers Community at large – States If the utility of the customer is greater than the price payed to the company, that is the customer’s surplus. Generally Revenues – Costs (exogenous variables) = Earnings (endogenous variable) Now Revenues, Costs and Earnings are simultaneously determined, as they result from a more complex system. There are no more exogenous or endogenous variables. Corporation Legal entity which is given the power to sign contracts with: Top manager Employee Supplier Customer Dispersed share ownership brings two problems: coordination and free riding Coordination because, in order to have an impact, it’s necessary to put together a certain amount of votes; free riding because, due to dispersion, managers have more information than the shareholders and board of directors and can make decision individually. free riding is the fact that u(Benefit(effort),cost)= d(u)/dB>0; if you are a shareholder, therefore the benefit of shareholders is be overhanded, since the personal benefit is less than total benefit, the effort will be more than the benefit. You pay the full effort. Link between the firm and capital structure → irrelevance of the capital structure if we look at the firm as a black box (we know that the capital structure does matter instead), there are cost of distress, a firm usually is worth more when it’s alive than when it’s dead. Capital structure is much more complex that equity, it implies a waterfall of payments; Capital structure is deciding how to split production of wealth and distribution of wealth. The position in the capital structure is going to tell the seniority of the claim (financial implications) Most of the governance right remain among people who have junior claim. Among the assets of a company there are certain assets that are remarked to repay senior secured claimholders first (inside collateral, the guarantee that is provided is inside the company, outside collateral, if the asset used to repay is detain by someone not inside the company). Presence of claimholder show us the “waterfall of payment” system: from senior secured debt, to senior unsecured debt, to subordinated debt, to equity instruments, to common equity. If the company is not able to repay subordinated debt, it will be driven to bankrupt!! Equity like instrument and common equity can be used to cover losses keeping the company alive; Equity like instruments: preferred share, saving share, privileged share Common equity (given to shareholders) is like a call option on the firm; Bond equity (given to bondholders) is like a long position on the firm and short on the call option; Link between the firm and the governance Market is based on bargaining among equal (outsourcing) Firm is based on power hierarchies Matter of reducing transaction costs = how difficult is to implement a transaction What are the factors that push towards power hierarchies instead of market? • Repetition of many transaction • When writing a complete contract would be impossible or if the contract is unenforceable • To make a very specific investment (obtain a certain quality product) Link between the firm and valuation Σ (payoff – outside option); firm is a nexus of contracts with a lots of people; each one of this actor can participate or leave the firm and his contracts; true value of a company is the sum of payoff of each one minus the value of outside option that they have if they bring their job somewhere else. Is more than only the value of the shareholders!! FIRM AS A BLACK BOX PRODUCTION FUNCTION Capital structure → irrelevant Corporate Governance → no implication, entity acting like a technician that is going to optimize the production function Valuation → sum of the future discounted profit = value of equity FIRM AS A NEXUS OF EXPLICIT CONTRACTS (1840-1960) Capital Structure → irrelevant, the value of a firm is the sum of its parts so an eventual liquidation cannot affect its overall value (no costs of financial distress). These costs are introduced considering the costs of renegotiating contracts. The less costly way to shift the leverage between shareholders and bondholders is changing the dividend policy. Corporate Governance → shareholders’ supremacy, they deserve the right to make decisions; even if they have the supremacy it’s not necessarily true that they’re going to exercise it. Equity is the only residual contract (according to the law) but in practice a firm’s decision influence the payoff of other members of the nexus. Bondholders are not fully protected by the decisions made by shareholders. All the other members of the nexus would be indifferent to the choice made by equity holder because they are contractually protected against any negative consequence. For control rights to be valuable the party in control must be able to make decisions that alter the distribution of payoffs among the members of the nexus. But this implies that contracting parties are not fully protected by explicit contracts. Valuation → cash-flow-to-equity approach which consists in the discounted value of future payments to equity. Σ discounted cash-flow-to-equity (equity value) It can be substituted with the discount-cash-flow analysis considering the capital structure irrelevance principle. Implications → changes in stock prices can be used to evaluate the social consequences of decisions FIRM AS A NEXUS OF EXPLICIT AND IMPLICIT CONTRACTS Implicit contracts are not available on demand and require one or both parties to have established reputation over time. So, the firm is a unique combination and can be worth more or less than the sum of its parts. The difference is the net of value of organizational assets and liabilities (VALUE OF ORGANIZATIONAL CAPITAL). Capital Structure → relevant; implicit contracts rely on repetition and reputation mechanism, so the counterpart signing the contract really matters, in order to ensure enforceability of the contract; financial distress viewed as the threat that a firm can be liquidated destroying the effectiveness of implicit contracts. A temporary shock can have very long-term consequences on the value of the firm. Different definition of a firm’s boundaries as the legal entity undertaking the financing does not coincide with the set of relationships affected by that financing. The need for implicit contracts suggests the existence of some inefficiencies in explicit contracting and justify government intervention. Corporate Governance → there are other residual claimants besides equity holders who may need to be protected (stakeholders). Unclear if the control should be given to shareholders, as the maximization of their interest may lead to inefficient actions. Stakeholder “mess”. Valuation → Σ claims of all stakeholders cash-flow to equity + cash flow to bondholders = enterprise value + goodwill (value of organizational capital) 1. the members of the nexus can be paid above or below their opportunity cost. Wedge between market price and opportunity cost of inputs so impossibility to identify the value created by a firm with the equity holders’ payoff. Stock price changes are not reliable indicators of welfare changes. 2. Existence of hidden organizational assets and liabilities. Value of organizational capital. FIRM AS A COLLECTION OF GROWTH OPTIONS Firm as a collection of assets in place and growth opportunities. Explanations of the glue between the two components (assets and opportunities) not provided. Capital Structure → relevant, insiders or outsiders; when assets and liabilities need to be financed with external equity, this imp edes the efficient exploitation of growth opportunities. Information asymmetries on the value of the assets in place between insiders and outsiders are responsible for the friction. Cost of financial distress: underinvestment in valuable project. The growth options cannot be easily separated from the existing firm in order to create a separate company. Corporate Governance → power to the person that holds the key to the corporate opportunity Valuation → we move from NPV approach to real option valuation; financial options are well-specified contracts with a clear owner and a defined payoff, instead, many real-world growth options are not clearly allocated to one owner and their payoff depends on the way the option is exercised (endogenously determined). Problem of exclusivity and appropriability. In real options there are potential competitors (also employees) who can grab the opportunity or take advantage of a delay in exercise in order to appropriate most of its net present value. Also, suppliers can partially exploit these opportunities. FIRM AS A COLLECTION OF ASSETS Firm as a collection of assets jointly owned. Contracts are incomplete, so there is the need to allocate the right to decide in events not specified by initial contracts. Decision right affects the distribution of the ex-post surplus created by an enterprise and also the incentive to generate it. Merger → change of the allocation of the residual right of control in a way that no contract could do Concept of residual rights of control Definition of the firm very close to the legal definition. Shortcoming: identification of control with ownership, right to withdraw an asset. Control allows to shift the allocation of wealth among people. Capital Structure → disciplinary role of debt as mechanism of transferring control/ownership; outside equity as a sort of debt with infinite face value with the ability to intervene and subtract the asset from the managers. Underplay the diversity of equity from debt and overplay the power to intervene of outside equity. A solution would be to find a role for control that is different from that of ownership. Ownership: right to withdraw a resource after specific investment have been made. Control: regulates the access to the asset before specific investments are made. It focuses on the firm after all the human capital specific investments have been done. Liquidation can produce a loss only if the market for individual assets is less liquid that the market for the whole firm. Managerial discretion can cause expropriation of wealth, misallocation of resources, lack of effort or skill (managers can retain their job even if they’re no longer qualified or if they don’t have the incentive to put a lot of effort). poor managers who resist being replaced might be the costliest manifestation of the agency problem as argued in Jensen and Ruback (1983). Expropriation of wealth Excessive reward Transfer pricing of asset or on product; overbuilding a purchase or underbuilding a sale “Perks”: less direct personal benefits Misallocation of resources Empire building Pet projects Lack of effort or skills Entrenchment (Excess retained earns don’t pay out the dividends, keeping the resources in the company) Managerial Opportunism, whether in the form of expropriation of investors or of misallocation of company funds, reduces the amount of resources that investors are willing to put up ex ante to finance the firm. Solution on the principal side: the principal can try to align the interests of the two subjects, can condition the agent’s behavior (putting covenants on what he can do and cannot do) and can monitor Solution on the agent side: commitments Another way to solve the problem: verification in court Capital structure is deciding how to split production of wealth and distribution of wealth; if we consider implicit contracts, capital structure could not more been described as his asset, but reputation starts to be important in the consideration of a firm. For implicit contracts, Modigliani- Miller is not valid. MODIGLIANI – MILLER THEOREM: Modigliani Miller said that capital structure is totally irrelevant watching black box model. COASE THEOREM: if there are no transaction costs, the initial allocation of property rights is irrelevant, parties will always end up with the best allocation of property rights ex post bargaining. Coase theorem affirm that, due to managerial opportunism, investors can try to bribe managers to avoid inefficient and risky projects. The Coase theorem doesn’t apply because of the duty of loyalty, which is introduced to avoid the situation in which manager constantly threaten shareholders. Pyramid schemes: to allocate investors’ funds, managers end up absconding with the money. This scheme is more common in countries with poor shareholder protection, because it is easier for controlling shareholders to make minority shareholders in existing firms pay for starting up new firms as partial subsidiaries without fully sharing with these minorities the benefits of a new venture. We say that a firm’s ownership structure is a pyramid when: 1. It has an ultimate owner, and 2. There is at least one publicly traded company between it and the ultimate owner. Thus, if a publicly traded company X has 43% of votes in a firm A, and an individual C has 27% of votes in X, then C controls A in an ownership structure that is a pyramid. Cross-shareholding, instead, is when the company owns any shares of its controlling shareholders or in the companies along the that chain of control. Related to opportunism, solution are Ex ante contracting to align interests: incentive contract with payoff contingent or flat salary. Incentive contracts involve risk. Managers have more concentrated wealth, while capitalist have a diversified portfolio and hence can diversify risk. Managers are less able to diversify risk, so the risk should be mitigated by capitalists and managers should be given a flat salary. In case of incentive contracts, the extra payment should be given correlating the effort with the action undertaken by the manager. Not correlating the pay just to the outcome. However, it’s very difficult to do so. Claw back rule: until a few years ago mangers compensation was paid on a yearly basis, resulting into a bonus for managers in the case of a positive performance. But sometimes, the performance can be positive or negative regardless of what the manager does. So, the yearly result depends on luck and uncertainty. Nowadays, managers’ compensation is clawed back if a good and profitable performance is not sustained for a given period of time; this is done to link the compensation to the action, and not to the yearly outcome. Sensitivity of managers’ compensation to the outcome: incentive contracts are not very powerful because the amount of wealth created is huge, and this could lead to a self-dealing problem. Power incentive scheme: you want to give high incentives to the manager if the result depends a lot on the effort put by the manager. The incentive will be grater when the manager is able to create wealth, but also when he’s able to destroy wealth. R = f (e) 2. Market for capital despite the agency problem: reputation and investors’ over optimism Event study: assessing the impact of an action to the stock price, evaluate the wealth effect After an announcement, the effect is immediately visible (1/2 days of delay in the market, called event window), it’s also possible to evaluate the price of the stock before the announcement. Looking just at the return may be misleading, because you don’t see just the announcement effect but also other sort of effects. For a proper evaluation it’s necessary to adapt the rate of return: calculating the difference between the rate of return and the return on the whole market. The event study evaluates the impact of the event on the value of the equity capital, not on the value of the entire firm. Using excess cash to finance investment project doesn’t allow to assess the worthiness of the investment opportunity, because the company already has the money. In the oil industry example, the event is the announcement of an oil exploration. Usually the worst agency problems occur in firms with poor investment opportunities and excess cash. Sample selection bias: managers will announce only the investment they believe are the best, therefore the results of such event studies will be biased, underestimating the agency cost. In the case of acquisitions, the problem of the sample selection bias doesn’t arise since almost all acquisitions of public companies are publicly announced. Every time managers take anti-takeover measures to keep their private benefits, the stock price falls, so we can conclude that the market doesn’t appreciate that the risk of a takeover is washed away. Poison pills are initiatives adopted by the board of directors of a company to make a takeover very hard or if not impossible, without management’s consent. 3 TYPES OF SHARE IN ITALY: • Common shares have a voting right in all shareholders’ meeting and are the last to be paid • Privileged shares have less voting rights, concerning only extraordinary meetings. They have less power but are more economic privileged: they pay higher dividend and they are refunded with priority • Saving shares have no voting rights, but they have an additional privilege in the payment of dividend and an additional priority in the refunding. At a certain point, the cost of defaulting or behaving not properly will exceed the cost of behaving properly, so if the cost of abusing of managerial discretion becomes lower than the benefit gained, it will lead to a backward recursion problem. 3. Giving right to investors that are legally protected (governance rights) Duty of care: managers have to take decision after a very careful evaluation. Shareholders should bear the risk, not managers, according to the business judgement rule (you cannot come in court to complain that the manager had a bad judgement taking that decision). This rule is based on the fact that decisions are taken under uncertainty conditions, so an action is associated with a set of outcomes, influenced also by the state of the world. 4. Concentrate ownership 5. Large shareholder allows to avoid the free-rider issue and the coordination issue. It’s the most common form except for USA and UK. 6. Cost of large investors: different interests between the large and small shareholders 7. Costs: not diversified investors usually bear excessive risk; they represent their own interest. At the beginning, concentrated ownership is positive, after 5% ownership profitability decreases, because the management is wealthy enough to prefer to use the firm to generate private benefits of control that are not shared by minority shareholders. There are 2 ways to replace the management: proxy fight or takeover 8. Disciplinary effect of debt, as a way to strip off control 9. What is the best mechanism? LAW AND FINANCE (third paper) Focus on the legal protection of outside capitalist. What drives the degree of protection is the type of legal system the country has. Civil-law (French, German and Scandinavian): different degree of protection of both shareholders and bondholders. Common-law 2 problems: Liquidation – reorganization Cost of liquidation: you can be too harsh, closing business ventures that could have survived Cost of reorganization: you can be too lenient 1. No automatic stay: the creditor is not able to repossess the collateral. In Italy if the judge proposes a solution of reorganization, this has to be approved by each class of creditors. 2. Secured creditor first paid. Sometimes employees and state or social security systems are paid even before secured creditors. In Italy secured creditors are paid first 3. Reorganization restriction, needing creditors’ consent. (Chapter 11 in the US, “concordato in bianco” in Italy), the company can go to court and ask for more time to find a deal with creditors. 4. Management does not stay after reorganization. 5. Reserve requirement as a remedial right In Italy parts of the earnings need to be set aside to a compulsory reserve (riserva statutaria). If the “capitale sociale” falls below 1/3 of its amount, the shareholders have to call an extraordinary meeting to increase and readjust equity. Goodwill = premium paid Relative to creditor rights, both GDP and legal family affect separately the legal protection. For managers, stock option could be seen as a covert mechanism of self-dealing. Also, managers, instead of return free cash to the shareholders, decide to reinvest it; If stock price falls when managers announce a particular action, then this action must serve manager interest rather than investors interests. In Britain and in Us a mechanism for consolidating ownership has emerged, named hostile takeover. In a hostile takeover, a bidder makes a tender offer to the dispersed shareholders of the target firm, and if they accept this offer, acquires control of the firm and so can replace, or at least control, the management. BOARD OF DIRECTORS Dispersed shareholder base: they are unable to run directly the company and they need to supervise the action of the manager with continuity. For this reason, Delegation of the task of supervision to some people that are going to form the board of directors (intermediate level of control). Second reason why the board of directors is needed: we don’t want a single person to decide the destiny of the company but instead to create a collective decision-making process. The board is the highest decision maker in the company; they decide about planning, business plan and budget. The board will subdelegate some power to the CEO (amministratore delegato). The person who is entitled to run the company can be a member of the board or not. The general manager is not a member of the board of director but is the highest employee in the company. Sometimes CEO and general manager are set in the same person, having a protection with a full-time contract in the company. Other times are two different people. CEO → outside relations GM → inside relations Functions: About management of the company − Planning: prepare the business plan (3-5 years horizon) and prepare the budget (1 year horizon) which have to set performance targets, either at a general level (expected earning, etc..) or on single aspects (cost reduction increasing in revenues, etc..) E(X) target − Define the risk appetite and risk management framework → RAF (Risk Appetite Framework) Define the risk capacity, the risk tolerance and the risk trigger (escalation process) This function is also associated to planning, there must be coherence between the target and the risk, the risk target [V(x)] is usually lower than the risk trigger[E(x)]. [In order to get positive incomes, think about what type of risk, the amount of risk expected, considering your economic situation. E(x) -> V(x).] To represent a random event, it’s necessary to work with random distributions, using usually two data: the mean and the variance About control for board of directors: − Evaluation on the adequacy of the organizational structure & procedures of the corporation (planning & control system and internal control system) Possibility to claim an eventual fraud from the management if it didn’t communicate with transparency Internal control system: internal audit that is going to verify the proper set of rules and that people are behaving properly. Control system has a proper structure and not complain with law or normal regulation of the company. − Prepare the financial reporting: communicate how the company is performing; it’s important to review this at least once a year, full of all the information. − Managerial decisions: some delegated to the CEO and/or entrusted to the general managers while others retained by the board of directors; − Secure continuity of the managerial position (succession plan) Prepare in advance a succession plan in case something unexpected happens and present the slate of candidates for board election. In Italy, where there are large shareholders, usually shareholders present their slate of candidates. In the US, where large shareholders are not common, it’s the board of directors which present his own slate of candidates for the next board. 3 types of board of directors acting in the world: Two tier board system: two tasks (control and management) assigned to two boards. German, Netherland, Austria, China There is a supervisory board and a management board which are completely separate. Management board is usually headed by the CEO and composed by the C-level executives. It has the task to undertake managerial decisions. The supervisory board stays above that and has the task of controlling the managing board. It shares the tasks of planning and risk management with the management board. Supervisory board are totally out of day-to-day decisions. In supervisory board there must be a represent of the employees, elected by members of trade unions. The financial report is prepared by the management board and needs to be approved by the supervisory board. Problem of managing the information flow. The supervisory board is composed not only by shareholders but also by members elected by trade unions. One tier board system: The board is entitled to all the functions and delegate some of them to the CEO. There’s not a problem of circulation of information among the directors, so it’s easier to manage information. Structure: Chairman of the board (in Italy called “presidente”): entrusted to organize the board’s meetings, gets to decide what to discuss during the meetings (set the agenda) and organize the information flow provided to the board members. His principal role is to manage the firm. The chairman can be elected by the board or nominated by the shareholder ‘s meeting. If he is elected by the board, the board can replace him at any time. CEO (in Italy used to be the same person as the chairman of the board): when those two roles stick together it’s necessary to nominate a lead independent director among the other members entitled to set the agenda and manage the information flow in absence of the CEO. CEO take decisions based on information flow harvest in the board meeting. Board members: divided in 3 categories. Executives, who are managers of the companies (usually very few in the board). Non-executive directors (NED), who are people with no involvement in the managing of the company, but they have economic or personal relations with the firm. Independent NED (INED) who have no economic relation with the firm and no personal relation with important managerial people among board members or shareholders. After 9 years in a board a person is going to lose his INED status. There is not a formal requirement between NED and INED, unless it is written in the statute. Split the tasks (manage and control) among the members of the boards: Empirical evidence shows that CEO power is negatively related to board independence, confirming what predicted by the theory. The CEO pay become less linked to equity performance, being less volatile over time. Dominguez-Martinez, Swank, and Visser model (2008) Assumption: the information available to the board depends on the willingness of the CEO to share this information 2 types of CEOs: good type, characterized by a higher probability of selecting a positive NPV project and bad type CEO, characterized by a higher probability of selecting a negative NPV project. Since the CEO prefers to retain his job, he has an incentive not to pursue the project. 3 strategies for the board of directors: 1. The CEO can be willing to push also negative projects: the board will receive a signal of his ability and can decide whether to keep him or not 2. Decide to dismiss the CEO if he doesn’t do anything → flip side: undertaking negative project is costly for the company 3. They can decide to retain the CEO → flip side: they are not able to assess the CEO’s ability This model is able to explain why the board incurs in bad decision making, in case we observe a project with negative NPV Model in figure 4 The greater the independence of the board, the greater will be the willingness to monitor the CEO. (additional cost so additional effort for the bord, buying costly signal related to CEO’s ability). This propension to buy costly signal can only increase the probability of dismissal of the CEO. On the one hand, there will be shorter average CEO tenures, on the other hand, the CEO will put more effort in running the company, asking for a higher salary in order to compensate for these two aspects. So, greater board independence tends to be related with a greater CEO compensation. Empirical evidence seems to confirm this model. 2. Structure Inside director: full-time employee of the firm Outside director: full-time employee of another firm Gray director: outside director of dubious independence 1989-1995: 55% outside 30% inside 15% gray Board size: 11 in 1936, 15 in 1960, 11 in 2000 It’s becoming more uniform over time (drop in standard deviation), and more outsider dominated. CEO = chairman of the board CEO duality can be associated to an excessive power to act in his own interest at the expense of other parties, so it can be viewed as a bad thing for the company. However, CEO duality can also be associated with positive outcomes, if it is given as a compensation for performing well. Staggered board: directors are elected for multiple years at a time, and only a fraction (usually a third) of the directors are elected in a given year. In case of takeover, the acquirer cannot take control of the company immediately. When firms “destagger,” return to annual elections for all directors, the market value of the firm should increase. The presence of a venture capitalist tends to persist over time, even after he has left the board of directors. CEO’s of another company as a director → expected to provide his expertise Stakeholders’ representative in the board, such as a labor representative to influence the board to take actions favorable to workers. Directors with a political background are often part of the board. We can basically distinguish two types of directors: lower type and higher type, described like that considering the question “Why some director chooses to be busier than others?”. Consequently, higher-type directors will optimally choose to do more activities than lower-type directors. Busier directors are higher types who would, thus, expend more effort per activity where they restricted to the same number of activities as less-busy (lower-type) directors. According to the number of utilities taken, for 9-type board the optimal number of activities (directorship) is 4, while for 15-type board director the optimal directorship is 6. 3. Functions The board works in teams. EXECUTIVE COMPENSATION (fifth paper) In this paper, we’ll explain which role government intervention may have on executive compensation and which kind of theory are currently available for explaining executive compensation. Cost vs value: cost is for shareholders; value is for manager. Cost is the same of the market value ONLY in grant date. Value for manager is less than the market value because of opportunity cost to receive the money instead of the restricted stock, instead receiving money in opposite of restricted stocks has more value for shareholder, cause they could use this money before stock grant; other variables are risk- averse rate. Government intervention has 2 roles: following the dynamics in compensation that market forces are providing and adapt to this evolving environment, once compensation has been introduced, there is a feedback effect. Government intervention is both a consequence and a driver. Efficient contracting hypothesis: optimal outcome to market forces, alignment between the interests of shareholder and manager, one way of solving or minimizing the agency problem. Managerial compensation: compensation is not a solution, is the best example of the agency problem, compensation determined by captive board members. Excessive pay as symptomatic of the agency problem. Transferring wealth from shareholders and bondholders to managers. We need to distinguish expected compensation (grant-date) from realized compensation (realized pay). To analyze measures of total compensation, we distinguish 3 way: 1. Grant-date pay (based on grant-date values for stock and options, and target value for bonuses.) 2. Realized pay (based on the vesting of stock awards and the gains from exercising options) 3. Risk-adjusted pay (expected pay from the perspective of risk-averse CEOs) They are not mutually exclusive. Example: broad use of stock option in the 90s was a good faith attempt to align the interest of managers to the interest of shareholders (closer payoff) → efficient contracting hypothesis At that time this type of compensation didn’t have to be recognized in the accounting book, perceived as free to grant. There was no cost for the company in the profit and loss statement, instead there was a huge cost of potential dilution. Managers were able to ask for an enormous compensation. Type of government intervention: Different type of interest (neither to reduce agency cost nor to exploit discretionary power), but instead to reach political consensus; governments are concerned in the absolute value of executive compensation and want to compress it. Tax, disclosure rules and listing requirements are the main tools. Another instrument could be a direct pay cap. Managers could try to get around these types of interventions. Objection: Murphy forgets to consider the power of lobbies. Different metrics: grant-date pay and realized pay. CEO wealth is linked indirectly with shareholder wealth also thanks to accounting-based bonuses, to year- to-year adjustments in salary levels, bonus and restricted stock grant sizes (tempo di arrivo dell’opzione). Sensitivity of pay regarding corporate performance are attributable to the direct part of the CEO’s contract, and this part can be measured from information available in corporate proxy statements. CEO’s share of ownership represents the agency problem, cause agency costs arise when agents receive less than 100% of the value of the output, and with risk aversion variable is always like that. In constructing an aggregate measure of CEO incentives, I weight each option by the “Option Delta,” defined as the change in the value of a stock option for an incremental change in the stock price. Option Deltas range from near zero (for deep out-of-the-money options) to near one (for deep in-the-money options on non-dividend paying stock). I call this measure the “effective ownership percentage” to distinguish it from the actual ownership percentage based only on stock (and not option) holdings. Equity at stake = effective ownership percentage multiplied by 1% of the firm’s market capitalization. CEO’s Effective percentage ownership for stock options is measured by weighting each option held by the executive at the end of the fiscal year by “Option Delta” for that option (which varies according to the exercise price and time remaining to exercise), and dividing by the total number of shares outstanding. This measure of effective CEO ownership is essentially the “pay-performance sensitivity”. Delta is represented by sensitivity. Usually, executives receive awards for upside risk, but are not penalized for downside risk, so they will take greater risks than if they faced symmetric consequences on both directions. Since the value of a stock option (or the value of equity in a leveraged firm) increases monotonically with stock-price volatilities, options (and limited liability) provide incentives for executives to increase such volatilities. In Section 2.2.1, the calculations for pay-performance sensitivities for stock options depended on the Option Delta, defined as the change in the value of a stock option associated with an incremental change in the stock price. Similarly, the calculations for pay-volatility sensitivities for stock options depend on the Option Vega, typically defined as the change in the value of a stock option associated with one percentage-point increase in the stock-price volatility (e.g., from 30% to 31%). Option Vegas are typically highest when stock prices are near the option’s exercise price. I consider two option-based measures for incentives to increase stock-price volatilities: Total Option Vega = Change in value of outstanding options for a 1% increase in volatility Vega Elasticity = percentage change in value of outstanding options for a 1% increase in volatily. Rather than measuring performance, you use benchmark to compare the result you obtain. You must make attention in the way you are going to select your benchmarks. SEC (securities exchange commission) = Consob Italiana, it regulates financial markets. THE ROLE OF BOARDS OF DIRECTORS IN CORPORATE GOVERNANCE (4° document) 1. Introduction It is difficult to estimate the day-to-day impact of corporate boards, they become the center of attention only when things go wrong like in Enron scandal and therefore, boards have been at the center of the policy debate concerning governance reform. But the ultimate question is: “what is the role of the board?” There are different answers from being a simply legal necessities from playing an active part in the overall management and control of the corporation. Undoubtedly the truth lies in the middle. Because it is difficult to observe differences in behavior and harder still to quantify for statistical studies, empirical work has focused on structural differences across the boards. For instance, NED will behave differently than ED therefore we can look at the conduct of boards with different ratios of outside to inside directors to see whether conduct varies in a statistically significant manner. When conduct is not directly observable, we can look at firm’s financial performance to see whether board structure matters. There is a problem: there is no reason to suppose board structure is exogenous, indeed theoretical argument and empirical evidence suggest that board structure is endogenous. Governance structures arise endogenously because economic actors choose them in response to the governance issues they face. Endogeneity has implications also for how to view governance practice and we need to ask why a structure was chosen. It is possible that it was chosen by mistake, but competition should lead to the survival of the fittest model. Fittest does not mean optimal and this existing suboptimality is not simple to understand quickly. However, endogeneity is easy to forget in face of data. A regression line through the points underscores the apparent negative relation between attribute and performance. In a first analysis we can affirm that there is a negative relation between financial performance and size of the board, but we do not consider why a large board would be chosen. For a given firm, there is a non-monotonic relation between the attribute and financial performance. The relation is concave and admits an interior maximum and each firm lies in the maximum. Obviously Firm 2 would prefer lie on the Firm 1’s curve but it can’t because different firms face different governance problems. The 2 figures show the heterogeneity of solutions for governance problem and almost every model of governance shows that the equilibrium outcome is sensitive to its exogenous parameters. To resolve heterogeneity, issue the theoretical analyses provided some empirical solution applying to board of directors’ specific topic of a general theory. For instance, issues of board collaboration would seem to fit into the general literature on free-riding and the teams’ problem. Regarding this last issue we would like to know what happens to total effort of boards (e.g., are larger boards less capable monitors because of the team’s problem). information is more valuable when a board is seeking to infer the ability of a relatively unknown CEO than a veteran because option to dismiss a poorly performing CEO is like a put option. Therefore, option valuer is greater, the greater is the amount of uncertainty. Thus, Hermalin examine the relationship between a board’s structure and its propensity to hire a new CEO from the outside or inside. Because internal hire is a better-known commodity, t an external hire offers the greater option value and therefore more valuable, ceteris paribus. How much more valuable depends on the degree to which the board will monitor the CEO. e board decides as to how intensively it will monitor the CEO, which is reflected in the probability it will get an additional signal correlated with his ability.17 Without the signal, there is no option value. For this reason, value of uncertainty is greater for a board what would likely acquire an additional signal. Due to a lot of factor like government regulation and new exchange requirements, boards have become more independent and diligent. More monitoring directly raises the likelihood of CEO dismissal and indirectly raises it if it leads firms to hire CEOs about whom less is known 3. How are boards of directors structured? 3.1. Some facts Inside director: full-time employee of the firm Outside director: full-time employee of another firm Gray director: outside director of dubious independence 1989-1995: 55% outside 30% inside 15% gray Board size: 11 in 1936, 15 in 1960, 11 in 2000 It’s becoming more uniform over time (drop in standard deviation), and more outsider dominated. 3.2.1. CEO-Chairman Duality Many CEOs also hold the title of Chairman of the Board; this duality holds in almost of 80% of large us firms (1991). This structure is viewed as diving CEO’s greater power than other parties. To mitigate this issue, observers of corporate governance have called for a prohibition on the CEO serving as chairman( Jensen, 1993). Some evidence: 1) Authors find little evidence that combining or separating CEO and chairman titles affects corporate performance 2) the sensitivity of ceo turnover to performance is lower when titles are combined 3) CEO who also holding chairman title appear to hold greater influence over corporate decision-making. Overall, combined titles are associated with ceos having more influence in the firm but isn’t clear whether relation is causal because influence inside an organization is endogenous. CEO who performs well would be rewarded by his being given the chairman title as well. It’s true that combining titles means an average more influence in the firm but it does not follow that mandating separate titles would improve corporate performance, in fact, measures of CEO power are not systematically related to firm performance. Hence, imposing separate titles would either yield a less optimal solution or lead to a, possibly inefficient, work- around that maintained the optimal amount of ceo power. 3.2.2. Staggered Boards Staggered board means directors are elected for multiple years (usually 3) at a time and only a fractions (usually 1/3) of them are elected in a given year. This is a way of shielding a firm from takeover because a potential acquirer can’t take the control quickly. It is very common; roughly half of the firms have classified by Faleye (staggered) boards. This arrangement is not in the shareholders’ interests and some authors find negative returns when firms announce they are classifying their boards. Furthermore, firms with staggered boards have lower value than other firms, using Tobin’s Q as a measure of value. For instance, when firms declares a return to annual elections of whole board of directors, value should increase. de-staggering is not typically initiated by managers, but by activist shareholders. Subsequent to the de-staggering, investors think that firms are more likely to be a takeover targets. 3.3. The Role of Particular Types of Outside Directors Outside directors typically have backgrounds that will enable them to be valuable to a board. 3.3.1. Bankers Many firms have bankers on their boards because they can monitor the firm for the lender for whom they work and because they can provide financial expertise. Some evidence: 1) When a director is affliated with a bank lending to the firm, the firm’s overall debt ratio is lower. It is consistent with a view such an affiliated director can protect the bank’s interest by discouraging the firm from taking out loans from other banks that could increase the risk to the director’s bank 2) adding commercial bankers to boards increases a firm’s ability to access debt markets but a lot of these firms have good credit and poor investment opportunities 3) having bankers on boards can be a double-edged sword. Bankers in the board can improve firm’s acces to capital market but this improved access can work to the benefit of the bank rather than the firm doing the borrowing. 3.3.2. Venture Capitalist Venture capitalists have a fiduciary responsibility to their own investors to exit these enterprises relatively quickly and thus leaving their seat in the board. Some evidence: 1) VC presence can affect firms long after they have left the board. 2) initial presence of a venture capital with strong reputation is likely to decrease the CEO’s bargaining power relative to the board. 3) high-reputation venture capitalist leads to a more powerful board, even after the venture capitalist exits his investment → a venture capitalist negotiates substantially more control rights than is typical for outside investors, this balance of power away from management tends to persist 3.3.3. Politically connected directors Firms that deal regularly with government, place a high value on being able to influence governmental decisions. Firms that are more reliant on governmental decisions are more likely to appoint directors with backgrounds in law and politics. 3.3.4. CEO’s as directors One of the most common occupations of outside directors is ceo of another firm thank to their management skills and thei capacity to understand the issues facing top management. There is no evidence that CEO’s on board add value for the firm, at least relative to other outside directors. Fellow ceos on the board may reduce firm value in at least one circumstance: when a ceo is added to a board as a part of an interlock. Interlock = 2 Firms (Palermo-Samp), 2 CEO (Federico-Andrea) Federico is CEO of Palermo and he is in the board of Samp. Andrea is the CEO of Samp and he is in the boardo of Palermo. When directors are added as interlocks firm’s performance declines, attributed to mutual “back-scratching” = implicit threat of what the first ceo can do for or against the second. Some evidence: 1) interlocked directors receive abnormally high pay 2) worse firm performance and higher ceo pay at firms in which the ceo has connections to the board. 3) measures of ceo bargaining power, evidence of ability, d sitting on the nominating committee—are positively correlated with interlocks, while ceo ownership is negatively correlated Overall, interlocks and other outside personal relationships between the ceo and his directors can be associated with poor performance. But interpreting result is difficult due to endogeneity issue: It is difficult to know if the board structure determines the firm’s performance or the board structure is merely a manifestation of the power a CEO 4. How Does the Board Work? 4.1. The Working of Teams A board of directors is a team, the literature widely treat working on team but the application of this theory does not lead to clear prediction. For instance, total board effort can increase or decrease with the size of the board. The work that best controls for those issues , finds ambiguous results: For “simple” firms, Tobin’s Q decreases in board size; while, for “complex” firms, it increases in board size. Complex firm= firm is one that scores above the median on an index of complexity directors may be presumed to prefer greater wealth to less wealth → responsive to fincancial incentives. Therefore firms use a lot of incetives including: 1) Additional fees for attending meeting 2) Stock and option grant 3) Performance bonuses Non sto qua a riportare i dati di come la paga cresce nel tempo ma fidati, cresce 5.1.1. Theory the basic ideas of incentive pay are well known and have been analyzed at depth but the 3-level hierarchy of shareholders-directors-management generates some additional issues, such as possible collusion between directors and management. Kumar and Sivaramakrishnan→ examine the role of the board in setting the ceo’s incentive compensation and the role of incentive pay for directors with respect to the performance of their duties. They found: 1) board independence and board incentive pay could be substitutes: independent boards could be less diligent monitors than less-independent boards so max independent boards could be not the best option for shareholders. Why? Less independent board, that consequently have less power of negotiation against CEO, has a stronger incentive than does a more-independent board to learn payoff-relevant information. Information helps to counterbalance their weaker bargaining position. The strength of the compensation incentives it requires is less than would be required by a more independent board. let’s explain the model: - 2 projects, same payoff V - different investment so I1 pays V, I2 pays V But I1<I2 → V>I2>I1 - p is the probability of project 1 before approaching the board for funds, CEO learns the project as a private information. With a c cost, board can learn the project. If they did it, CEO would know it but not shareholders. CEO preference are u(w)+1 → w = compensation, u() = utility for money A literature assumption says that CEO prefers to run a larger project in terms of I so he would choice I2 because I2 > I1. There is no incenti contract that can be employed. There are 2 type of board: 1) independent, utility = a(V-I) and a = proportion of the firm granted the directors as an incentive 2) dependent, utility = a(V-I)+ dI where d>0 reflects the board dependence. Next the ceo learns the project type and the board, if it elects to expend c, also learns the type, CEO seeks approval from the board to invest. Finally, tha payoffs are realized. To solve: Board is ignorant, it can fund all projets I2 proposed by CEO or allowing the CEO to pursue I1. From shareholders’/independent board perspective, the board should pursue I1 if: p(V-I1)> V- I2 The shareholders/independent board forgo some profitable investment to avoid paying the ceo an information rent while a dependent board will fund all projects if: a(V-I2) +dI2> pa(v-I1)+pdI1 It is possible that both disequations hold in which case the shareholders are worse off with an ignorant dependent board than they would be with an ignorant independent board. Boardz does not have to remain ignorant, it can chose to pay c to learn project type, will fund all of them and restrict CEo to I1. The expected payoff is V-pI1-(1-p)I1→ this is highest EV the firm can have. expending c would be a waste if the dependent board was so weak that it would approve funding of I2 even the project was 1 type. To avoid that: a(V-I1)dI1>= a(V- I2)+dI2. It holds if a>=d Ih=I2; Il=I1 Remember that probability of I2 is small while I1 is large and less costly y for the shareholders to induce a dependent board to learn the project’s type. Because a dependent board knows it will lose more in the future if ignorant, the value of information is intrinsically greater for it. Because it can be cheaper to induce a dependent board to learn the project’s type, shareholders can rationally prefer a dependent board to an independent 5.1.2. Empirical work Vafeas conducts a matched-sample analysis with a sample of 122 firms that adopted a director compensation scheme. Compensation scheme = plan providing for the grant of stock or options Some evidence: 1) strongly significant predictor of adoption is the proportion of outside directors, which is positively related to adoption 2) after 3 years, adopters continue to have a higher proportion of outside directors. 3) firms that adopt tend to be larger, , are less likely to have an unaffiliated blockholder, and have busier directors 4) adopting firms are more reliant on the board as a monitoring device and, thus, contingent compensation is part of this governance strategy. Consistent with Vafeas, Bryan and Klein (2004) find evidence: 1) t firms with greater agency problems make greater use of option compensation for outside directors 2) d no evidence that the percentage of outside directors is a significant predictor of option compensation → contrast with vafeas. Fich and Shivdasani(2004): 1) firms with high market-to-book ratios are more likely to utilize option compensation for their directors. 2) stock market reacts favorably to the adoption of a director stock-option plan 3) Adoption also led to an improvement in the EPS forecast. So, instead of being a solution, director compensation plans are evidence of an unresolved agency problem. Brick finds: 1) strong positive correlation between excess ceo compensation and excess director compensation 2) If the regression residuals were truly random errors, then they should be uncorrelated. → Correlation indicates systematic factors within each firm 3) one such systematic factor could be “cronyism” between the directors and the ceo; that is, the directors and ceo collude together against the shareholders to improperly increase their compensation. Other authors have sought to determine whether incentive pay for directors has an effect on their actions: 1) receiving as little as $1000 per meeting significantly increases attendance 2) incentive pay makes outsider-dominated boards even more likely to dismiss the CEO for poor financial performance. 5.2. Reputational Concerns Beyond compensation, reputations could be a driver of motivation because directors have for being seen as able business people → concern for his reputation will cause an agent to act more in his principal’s interests than standard agency but reputational concerns are not sufficient to eliminate agency problems. Directors’ reputations would seem particularly important in the market for directorships. A strong reputation presumably aids in getting more board seats or retaining the ones already held. Some evidence: 1) poorly performing ceos are less likely to gain board seats on other companies than well- performing ceos 2) cumulative abnormal return in response to the addition of a director who is ceo of another firm is significantly greater the higher the industry-adjusted roa of his firm is 3) outside directors are no more likely to leave the board of the sued firm than they would be otherwise, however, they see a significant drop in other board seats held and the size of drop is greater the more severe the fraud allegation or when they bear a greater responsibility for monitoring fraud.