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Journal of
CORPORATE
FINANCE
E LSEVIE R Journal of Corporate Finance 3 (1997) 113 139
B o a r d s o f d i r e c t o r s a n d c a p i t a l s t r u c t u r e :
A l t e r n a t i v e f o r m s o f c o r p o r a t e r e s t r u c t u r i n g
E r n st M a u g *
F u q u a S c h o o l o f B u s i n e s s , D u k e U n i t, e r si ty , P . O . B o x 9 0 1 2 0 , D u r h a m , N C 2 7 7 0 8 , U S A
A b s t r a c t
This paper discusses a model that combines internal and external control mechanisms in
a firm in which assets can have alternative uses that are in some states more profitable than
the current one. However, restructuring a firm in order to realize the gains from alternative
uses affects managers adversely since they invest in firm-speci fic human capital. Managers
can be motivated to restructure the firm through their compensation scheme. Alternatively,
investors can acquire costly information on the firm and interfere with managers' decisions.
The main focus is on independent directors, who review and monitor contracts and
managers' compensation. If information is not too costly, directors are the optimal
institution to check managerial discretion and the degree of managerial entrenchment
depends on the compensation of independent directors. However, if directors fail to exercise
control over management properly, takeovers or creditor control become second-best
solutions. If information is costly to transfer, unchecked managerial control may be optimal.
JEL classif ication." G32; G33:G34
Keywo rd s . "
Capital structure; Corporate restructuring; Internal control mechanisms; Boards of directors
: Takeovers; Agency theory
* Tel.: ( +1) 919-660.7753; fax: (+1) 919-660.8038; e-mail: [email protected]; web:
http://www.duke.edu/~ maug.
0929-1199/97/$17.00 Copyright 1997 Elsevier Science B.V. All rights reserved.
P I I
S0929-1199(96)00010-7
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1 1 4
E. Maug /J ournal q[Corporate Finance 3 (1997) 113 139
T h e t r ad e o f a j o i n t s t o ck c o m p a n y i s a l w a y s m a n a g e d b y a c o u r t o f
d i r e c t o r s . T h i s c o u r t , i n d e e d , i s f r e q u e n t l y s u b j e c t (. . .) to t h e c o n t r o l o f a
g e n e r a l c o u r t o f p r o p r ie t o r s . B u t t h e g r e a t e r p a r t o f th e s e p r o p r i e t o r s s e l d o m
p r e t e n d t o u n d e r s t a n d a n y t h i n g o f t h e b u s i n e s s o f t h e c o m p a n y ; a n d w h e n
t h e s p i ri t o f f a c t i o n s h a p p e n s n o t t o p r e v a i l a m o n g t h e m , g i v e t h e m s e l v e s n o
t r o u b l e a b o u t i t, b u t r e c e i v e c o n t e n t e d l y s u c h h a l f y e a r l y o r y e a r l y d i v i d e n d ,
a s t h e d i r e c t o r s t h i n k p r o p e r t o m a k e t o t h e m . A d a m S m i t h (1 9 2 5 , p . 2 6 2 )
1 . I n t r o d u c t i o n
H o w c a n m a n a g e r s i n a l a r g e c o r p o r a t i o n b e h e l d a c c o u n t a b l e , s o t h a t t h e y a r e
r e s p o n s i v e t o t h e i n t e r e s ts o f s h a r e h o l d e r s a n d s t il l h a v e s u f f i c ie n t d i s c r e t i o n o v e r
b u s i n e s s d e c i s i o n s ? T h i s p a p e r i n v e s t i g a t e s t h e r o l e o f i n d e p e n d e n t d i r e c t o r s l o m
a n o p t i m a l c o n t r a c t i n g p e r s p e c t i v e , a n d t r ie s to s h o w h o w t h is i n s t i tu t i o n c a n b e
u n d e r s t o o d a s a n a n s w e r t o th i s q u e s t i o n . T h e a i m i s t o c o n t r a s t i n d e p e n d e n t o r
o u t s i d e d i r e c t o r s w i t h a l t e r n a t i v e m e c h a n i s m s t h a t r e g u l a t e t h e a g e n c y r e l a t i o n s h i p
b e t w e e n e x e c u t i v e m a n a g e m e n t a n d s h a r e h o l d e rs , s u c h a s th e m a r k e t f o r c o r p o r a t e
c o n t r o l , o r t h e c o n t r o l e x e r c i s e d b y c r e d i t o r s t h r o u g h d e b t c o n t r a c t s .
A d a m S m i t h ( 1 9 2 5) b e l i e v e d th a t t h e a g e n c y p r o b l e m b e t w e e n o w n e r s a n d
m a n a g e r s p o s e d s u c h a n o b s t a c l e a s t o m a k e i t q u e s t i o n a b l e w h e t h e r th e m o d e m
c o r p o r a t i o n w i t h i t s s e p a r a t i o n o f o w n e r s h i p a n d c o n t r o l is a v i a b l e i n s ti t u ti o n .
H o w e v e r , t h e s e p a r a t io n o f o w n e r s h i p a n d c o n t r o l h a s p r o v e d t o b e v i a b l e, t h e re b y
i n d i c a t i n g th a t th e i m p l i e d a g e n c y p r o b l e m c a n b e r e g u l a t e d e f f e c t i v e l y .
T h e m o d e l d i s c u s s e d b e l o w f o c u s e s o n a c o r p o r a t e re s t ru c t u r in g p r o b l e m in
o r d e r t o c o m p a r e a l t e r n a t i v e g o v e r n a n c e s t r u c t u r e s. T h e a s s e t s o f t h e f ir m h a v e
a l t e r n a t i v e u s e s t o t h e c u r r e n t o n e , a n d i n s o m e s t a t e s i t i s o p t i m a l t o r e a l l o c a t e t h e
a s s e t s ( e . g . a d i v e s t i t u r e ) . I n t h i s c a s e m a n a g e r s h a v e t o w r i t e o f f a p a r t o f th e i r
f i r m - s p e c i f i c h u m a n c a p i t a l . H e n c e , t h e m o d e l i s se t up t o c o v e r t w o e l e m e n t s o f
r e s t r u c t u ri n g : ( 1 ) m a n a g e r s a r e p o t e n t i a l l y o p p o s e d t o r e a l l o c a t i n g t h e a s s e t s s i n c e
t h e y h a v e a p r i v a t e s t a k e i n t h e i r c u r r e n t u s e ; a n d ( 2 ) i f m a n a g e r s r e l y o n i m p l i c i t
c o n t r a c t s w h i c h c a n b e b r e a c h e d , t h e n r a t i o n a l l y a n t i c i p a t e d re s t r u c t u r in g s c a n l e a d
t o u n d e r i n v e s t m e n t in h u m a n c a p i t a l. T h e n m a n a g e r s a r e p r o t e c t e d f r o m s u c h a
b r e a c h b y g i v i n g th e m a ll r i g h ts o f c o n tr o l a n d a h i g h - p o w e r e d c o m p e n s a t i o n p l a n
t h at m o t i v a t e s th e m t o m a k e o p t i m a l u s e o f t h e c o m p a n y ' s a s s et s . M a n a g e r s c a n
t h u s b e p r o t e c t e d b y a n e x p l i c i t c o n t r a c t t h a t c a n n o t b e b r e a c h e d , b u t t h i s is n o t
o n l y a v e r y e x p e n s i v e w a y t o i n d u c e c o r r e c t d e c i s i o n s , i t a l s o f a il s t o s o l v e t h e
u n d e r i n v e s t m e n t p r o b l e m . O u t s i d e i n v e s t o r s ( c r e d i t o r s , t a k e o v e r r a i d e r s ) o r a
s u p e r v i s o r y b o a r d o f d i re c t o r s c a n p o t e n t i a l l y a l l e v i a t e t h is p r o b l e m . H o w e v e r , i n
o r d e r to c h e c k m a n a g e r s ' d e c i s i o n s e f f e c t i v e l y t h e y h a v e t o a c q u i r e c o s t l y
i n f o r m a t i o n .
I n d e p e n d e n t d i r e c t o r s a r e a n a l y z e d a s a g e n t s s e p a r a t e f r o m e x e c u t i v e m a n a g e -
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E. Mau g / Journal o f Corporate Finance 3 (1997) 113-139 115
m e n t w h o s e m a i n f u n c t i o n i s t o m o n i t o r a n d r e n e g o t i a t e c o n t r a c t s , b u t w h o a r e n o t
p a r t o f th e p r o d u c t i v e a c t i v i t y o f th e f i r m a s s u c h . I n p a r t i cu l a r , t h e y h a v e n o
v e s t e d i n t e r e s t s i n s p e c i f i c o p e r a t i n g d e c i s i o n s . T h e y a r e a l s o d i f f e r e n t f r o m o t h e r
o u t s i d e s h a r e h o l d e r s b y b e i n g a b l e t o n e g o t i a t e b i l a t e ra l l y w i t h e x e c u t i v e m a n -
a g e rs . D i r e c t o r s ' a b i l i ty t o n e g o t i a te o v e r t h e r e m u n e r a t i o n o f e x e c u t i v e m a n a g e r s
i s c r u c i al t o t h e m o d e l h e r e . T h e y c a n i n d u c e a n o p t i m a l u s e o f th e c o m p a n y ' s
a s s e t s w i t h o u t b r e a c h i n g i m p l i c i t c o n t r a c t s . T h e a r g u m e n t b e l o w e m p h a s i z e s t h e
e s s en t ia l r o l e o f th e i r in d e p e n d e n t j u d g e m e n t . W e a k d i r ec t o rs w h o a r e n o t
i n d e p e n d e n t d o n o t o n l y h a r m s h a r e h o l d e rs t h r o u g h e x c e s s i v e p a y a w a r d s - a n
a s p e c t u s u a l l y e m p h a s i z e d i n t h e p u b l i c d e b a t e - b u t a l so b e c a u s e t h e y r e d u c e t h e
l i n k b e t w e e n p a y a n d p e r f o r m a n c e .
C a p i t a l s t r u c t u r e c a n b e u s e d t o t r a n s f e r c o n t r o l f r o m m a n a g e r s t o s e c u r i t y
h o l d e r s : e i t h e r t o c r e d i to r s i n b a n k r u p t c y , o r to r a id e r s i n t a k e o v e r s . T h e s e
m e c h a n i s m s c a n b e e f f e c t i v e i n r e a l l o c a t i n g r e s o u r c e s . H o w e v e r , t h e y c a n b r e a c h
i m p l i c i t c o n t r a c t s o n w h i c h m a n a g e r s a n d o t h e r s t a k e h o l d e r s i n t h e c o r p o r a t i o n
r e ly w h e n m a k i n g f i r m - s p e c i f ic i n v e s t m e n t s. C o n v e r s e l y , l e ss d i s r u p t iv e m e c h a -
n i s m s l i k e f r i e n d l y t a k e o v e r s m a y f a i l t o p r o v i d e s u f f i c i e n t i n f o r m a t i o n t o o u t -
s i d e rs s o t h a t t h e r e s t r u c t u r i n g p o t e n t i a l o f t h e f i r m i s n o t e x p l o i t e d .
T h e f o l l o w i n g s e c t i o n r e l a te s t h e a r g u m e n t o f t hi s p a p e r t o th e l it e ra t u re . T h e
r e m a i n d e r o f th is p a p e r p r o c e e d s b y d e v e l o p i n g t h e m o d e l a n d d e r i v i n g t h e
f i r s t - b e s t a l l o c a t i o n a s a b e n c h m a r k c a s e ( S e c t i o n 3 ) . S e c t i o n 4 . 1 d i s c u s s e s t h e
c a s e w h e r e m a n a g e r s a r e n o t c o n s t r a i n e d b y o t h e r a g e n t s a n d s u b j e c t o n l y t o a
c o m p e n s a t i o n c o n t r a c t . S e c t i o n 4 . 2 is d e v o t e d t o t h e a n a l y s is o f c o r p o r a t e b o a r d s
a n d p r e s e n t s t h e m a i n r e s u l t s o f th e p a p e r . S e c t i o n s 4 . 3 a n d 4 . 4 i n v e s t i g a t e t o w h a t
e x t e n t c a p i t a l s t r u c t u re c a n s e r v e a s a su b s t i tu t e f o r i n d e p e n d e n t d i r e c t o r s a n d
a n a l y z e t a k e o v e r s a n d d e b t c o n t r a c t s . S e c t i o n 5 d i s c u s s e s e m p i r i c a l i m p l i c a t i o n s
a n d c o n c l u d e s .
2 . D i s c u s s i o n o f th e l i t e r a tu r e
B e r l e a n d M e a n s ( 1 9 3 2 ) p r o v i d e d t h e fi r st c o m p r e h e n s i v e a n a l y s is o f t h e
o r g a n i z a t i o n a l s o l u t i o n s t h a t h a v e b e e n d e v e l o p e d i n o r d e r t o b a l a n c e t h e n e c e s s i t y
o f m a n a g e r i a l d i s c r e ti o n a g a i n s t th e h a z a r d s o f u n c h e c k e d m a n a g e r i a l p o w e r . I n
t h e i r s e m i n a l p a p e r J e n s e n a n d M e c k l i n g ( 1 9 7 6 ) s t r e s s t h e c o n t r o l r i g h t s o f
d i f f er e n t m e m b e r s o f t he c o r p o r a t i o n i n t h e c o n t e x t o f t h e ir ' n e x u s o f c o n t r a c t s ' -
a p p r o a c h . T h i s v i e w w a s f u r t h e r e l a b o r a t e d b y F a m a a n d J e n s e n ( 1 9 8 3 a , b ) w h o
r e l a t e t h e s t r u c t u re o f r e si d u a l c l a i m s t o t h e o r g a n i s a t i o n a l s t r u c t u r e o f t h e f ir m .
T h e i r d i s t in c t i o n b e t w e e n ' d e c i s i o n m a k i n g ' a s a n e x e c u t iv e f u n c t io n , a n d ' d e c i -
s i o n c o n t r o l ' a s a s u p e r v i s o r y t a s k c o r r e s p o n d s t o t h e d i v i s i o n o f t a s k s b e t w e e n
e x e c u t i v e m a n a g e r s a n d i n d e p e n d e n t d i r e c t o r s i n t h e m o d e l p r e s e n t e d i n th i s p a p e r .
T h i s d i s t in c t i o n is a ls o e m p h a s i z e d b y L o r s c h a n d M c I v e r ( 1 9 8 9 ). F o r m a l d i s c u s -
s i o n s o f t h e r o le o f c o r p o r a t e b o a r d s a s d i s ti n c t f r o m e x e c u t i v e m a n a g e m e n t
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116 E. Maug / Journal of Corporate Finance 3 (1997) 113-139
appeared only very recently (Hirshleifer and Thakor (1991, 1994), Warther
(1994)). However, these papers emphasize the role of boards in dismissing
underperforming managers, whereas the model discussed in this paper emphasizes
the role of the board as a negotiator over managerial pay. Berkovitch and Israel
(1996) analyz e the board as an institu tion represen ting different stakeholders.
The literature on the market for corporate control is vast and will not be
discuss ed here. 1 The mos t imp ortant aspect here is the hypothesis of Shleifer and
Summers (1988) that takeover premia are largely explained by transfers of wealth
from corporate stakeholders to shareholders and a breach of implicit contracts (see
Schnitzer (1995) for a formalization of this argument). This paper emphasises the
ex ante incentives to invest in specific skills. These incentives are impaired if
implicit long term contracts are vulnerable to breach in future reorganisations of
the firm, even though the transfers caused by such a breach may be small relative
to other gains from a takeover. 2 The paper adopts the 'substitute hypothesis'
which holds that boards are an alternative mechanism to hostile takeovers. 3
The analysis of debt contracts follows a more recent approach that views debt
as a mech ani sm that allocates control conting ent on the state between insiders
(managers) and outside investors in a world where contracts are incomplete (cf.
Aghion and Bolton, 1992; Zender, 1991). This literature has opened up perspec-
tives which vi ew debt as a device con stra ining managerial discretion (see Hart,
1993; Hart and Moore, 1995; Jensen, 1986). However, such a use of debt causes
problems similar to those with takeovers, since control is assumed by security-
holders who are not bound by implici t contractual arra ngement s.Berk ovitch et al.
(1994) show that bankruptcy law can mitigate this problem.
3 . D e s c r i p t i o n o f t h e m o d e l
Consider a project which has been undertaken in the past and yields a state
cont inge nt payoff y~ where s denotes the state of nature. The payoff y~ depends
on the state which can take on three values, namely H, M, and B
(high/middle/bad). The assets of the project have alternative uses which are not
known until after the state of nature has been revealed. Realizing the returns from
alternative uses requires major restructuring. Restructuring involves redeploymen t
of the assets and their use under a different management. This restructuring
decision will be referred to as a choice between project closure and project
t See Jarrell et al. (1988) for a survey of the empirical iterature and Weston et al. (1990, appx. A),
for a textbook discussionof major theoretical contributions.
2 Empirical studies have not found much evidence for the claim that such transfers of wealth can
explain takeover premia (e.g. Lichtenberg and Siegel, 1990; Rosett, 1990).
3 Cf. Kini et al. (1995) and Shivdasani (1993) for empirical support and Hirshleifer and Thakor
(1991) for a discussionof the alternative complementarityhypothesis'.
i
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E. Maug / Journal of Corporate Finance 3 (1997) 113 139 117
c o n t i n u a t i o n . T h e r e t u r n s f r o m r e s t r u c t u r i n g a r e d e n o t e d b y L ~ ( t h e n Ys = L ~); i f
t h e p r o j e c t i s c o n t i n u e d i t y i e l d s
x s
( th en Ys =
X s ) .
A l l v a l u e s a r e e x p r e s s e d i n
p r i c e s o f s t a g e 1 .
T h e f i r m i s r u n b y m a n a g e r s w h o m a k e h u m a n c a p i t a l i n v e s t m e n t s . T h e h u m a n
c a p i t a l i n v e s t m e n t s c a n b e e i t h e r g e n e r a l o r s p e c i f i c t o t h e f i r m . T h e i n v e s t m e n t i n
h u m a n c a p i t a l i s n o t m o d e l l e d e x p l i c i t l y h e r e . T h i s a s s u m e s t h a t t h e t o t a l a m o u n t
o f in v e s t m e n t i n h u m a n c a p i t a l ( g e n e r a l p l u s s p e c i f i c ) is g i v e n , s o th a t o n l y t h e
c h o i c e o f t h e s p e c i f i c i ty o f h u m a n c a p i t a l n e e d s t o b e c o n s i d e r e d . T h i s s p e c i f i c i t y
o f h u m a n c a p i t a l i s r e p r e s e n t e d b y o n e v a r i a b l e h , w h e r e h l i es i n t h e c l o s e d u n i t
i n t e r v a l a n d c a n b e t h o u g h t o f a s a n i n d e x . T h e f o l l o w i n g a s s u m p t i o n d e s c r i b e s t h e
t e c h n o l o g y o f t h e p ro j e c t : th e s p e c i f i c i t y o f h u m a n c a p i t a l h i n c r e a s e s e x p e c t e d
p r o f i t s , a n d p r o f i t s i n e a c h s t a t e a r e a f f e c t e d b y t h e c l o s u r e d e c i s i o n . T h e l a s t
a s p e c t i s d e t a i l e d f u r t h e r i n A s s u m p t i o n 2 .
A s s u m p t i o n l ( P r o d u c t i o n ) .
( i ) Y s d e p e n d s o n t h e c o n t i n u a t i o n d e c i s i o n :
{L II i f c o n t i n u e d ,
Y~ = i f c lo sed .
( ii ) T h e s p e c i f i c i ty o f m a n a g e r s ' h u m a n c a p i t a l d e t e r m i n e s t h e l i k e l i h o o d o f
m o r e p r o f i t a b l e s t a t e s :
YH
w i t h p r o b ab i li ty p , ( h ) ,
3(, =
YM
w i t h p r o b a b i l i t y I
- - P H ( h ) - - P B , ,
YB w i t h p r o b a b i l i t y P B
w h e r e
p , ( h )
i s i n c r e a s i n g a n d c o n c a v e , h ~ [ 0 ; 1 ] a n d p ~ / ( 0 ) = ~ c, p ~ ( 1 ) = 0 .
( i i i ) x H >
x g > x ~
P a r t s (i ) a n d ( ii ) o f A s s u m p t i o n 1 s u m m a r i z e t h e p r e v i o u s d i s c u s s i o n a n d
i m p o s e s o m e r e g u l a r i t y c o n d i t i o n s . N o t e t h a t t h e p r o b a b i l it y o f th e l o w s t at e B i s
i n d e p e n d e n t o f h . T h i s a s s u m p t i o n f a ci li t at e s p r o o f s a n d i s fo r c o n v e n i e n c e o n l y .
T h e d e f i n i n g c h a r a c t e r i s t i c o f s t at e s i s t h e r a n k i n g o f c o n t i n u a t i o n p r o f i t l e v e l s
x s
i n ( i i i ) . 4 M a n a g e r s a r e r i s k n e u t r a l a n d m a x i m i z e e x p e c t e d u t i l i t y . T h e y n e g o t i a t e
c o n t r a c ts w i th t h e o r i g in a l o w n e r s o f th e f i rm . T h e s e c o n t r a c ts s p e c i f y p a y m e n t s
/ z ( y . ~ ) c o n t i n g e n t o n p r o f i t s . T h e m a n a g e r s d o n o t c a r e a b o u t t h e s p e c i f i c i t y o f
t h e i r h u m a n c a p i t a l i n v e s t m e n t h a s l o n g a s t h e p r o j e c t i s c o n t i n u e d , a n d t h e e f f o r t
f o r in v e s t i n g i n s o m e k i n d o f h u m a n c a p i ta l d o e s n o t n e e d t o b e c o n s i d e r e d h e r e .
H o w e v e r , i n v e s t i n g i n a h i g h l e v e l o f f i r m - s p e c i f i c h u m a n c a p i t a l i m p l i e s t h a t t h e i r
4 The re is no restricti on on the ra nking of L B,
L M
and L H ; cf Ass umpt ion 2 below .
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118 E. Ma ug / Journa l t)f Corporate Finan ce 3 (1997 ) 113-1 39
v a l u e i n t h e o u t s i d e l a b o u r - m a r k e t h a s d e c r e a s e d . 5 I f t h e p r o j e c t i s d i s c o n t i n u e d ,
t h e y s u f f e r a u t i l i t y l o s s
D ( h ) ,
w h i c h i s c o n t i n u o u s , i n c r e a s i n g a n d c o n v e x i n h .
O n e i n t e r p r e t a t i o n o f
D ( h )
i s t h a t m a n a g e r s h a v e l o w e r c a r e e r - p r o s p e c t s i f t h e
h u m a n c a p i t a l th e y h a v e a c q u i r e d i s s p e c i f i c to t h e f ir m r a t h e r th a n o f g e n e r a l
a p p l i c a b i l i t y . A l t e r n a t i v e l y , t h e u t i l it y lo s s m a y b e v i e w e d a s a s e a r c h c o s t t h a t
m a n a g e r s i n c u r i f t h e y h a v e t o l o o k f o r n e w e m p l o y m e n t . 6 Y e t a n o t h e r i n t e rp r e t a -
t i o n is th a t m a n a g e r s ' a v e r s i o n t o r e a l l o c a t i n g t h e a s s e ts i s r e l a t e d to t h e c o m m i t -
m e n t a n d s k i l l t h e y d e v o t e t o t h e p r o j e c t ' s d e v e l o p m e n t . M a n a g e r s ' o b j e c t i v e c an
b e r e w r i t t e n a s
U M = E ( t ~ ( y ~ ) )
- P ( l ) D ( h )
( 1 )
w h e r e E ( . ) d e n o t e s t h e e x p e c t a t i o n s o p e r a t o r a n d P ( I ) t h e p r o b a b i l i t y o f c l o s i n g
t h e p r o j e c t u n d e r p o l i c y 1 . l r e p r e s e n t s t h e s e t o f s t a t e s i n w h i c h t h e p r o j e c t i s
c l o s e d ( e . g . 1 = { B} i n d i c a t e s t h a t i t i s c l o s e d i f a n d o n l y i f s = B ; t h e n P ( 1 ) = P n ;
s i m i l a r l y , i f 1 = { B , M } , t h e n
P ( 1 ) = 1 - P H ) .
T h e f o l l o w i n g a s s u m p t i o n f u r th e r d e f i n e s s t a te s a n d is m a d e i n o r d e r t o
i n t r o d u c e t h e p o s s i b i l i t y o f i n e f f i c i e n t d e c i s i o n s a b o u t t h e u s e o f t h e a s s e t s .
A s s u m p t i o n 2 ( S t a t e s ) .
( i ) L H - - x H < O
( i i ) D ( O ) > L M - x M > O
( i i i )
0 < D ( I ) < L ~ - x n
( i v ) ( p n ( l ) - - P u ( 0 ) ) ( x n - - x M ) < p s ( L , - x , ) .
( s t a t e H ) ,
( s t a t e M ) ,
( s t a t e B ) ,
I n s t a te H , n o b o d y w o u l d c o n s i d e r c l o s i n g a p r o j e c t. I n s ta t e M , i t i s p r i v a t e l y
b u t n o t s o c i a l l y o p t i m a l t o r e s t ru c t u r e s i n c e t h e g a i n s d o n o t e x c e e d t h e p e c u n i a r y
e q u i v a l e n t o f t h e u t i l i t y - l o s s t h e y i n f l i c t o n m a n a g e r s . I n s t a te B , i t is p r i v a t e l y a n d
s o c i a l l y o p t i m a l t o r e d e p l o y t h e a s s e ts . O n l y t h e s e t h r e e s i t u a t io n s m a t t e r s i n c e
t h e y d e s c r i b e t h e c o n f l i c t o f in t e r e s t b e t w e e n o w n e r s a n d m a n a g e r s . O u t s i d e r s w h o
m a k e d e c i s i o n s c o n t in g e n t o n p e c u n i a r y r e tu r n s o n l y w i ll re s t ru c t u re w h e n e v e r
L - x > 0 e v e n i f t h i s d i f f e r e n c e i s r e l a t i v e l y s m a l l .
A s s u m e t h a t h i s o b s e r v a b l e b u t n o t c o n t r a c t i b l e . T h e n m a n a g e r s c a n n o t i n s u r e
t h e m s e l v e s a g a i n s t p r o j e c t c l o s u r e b y w r i t i n g c o m p e n s a t i o n p a y m e n t s i n t o t h e i r
c o n t r a c t s c o n t i n g e n t o n h . T h e o n l y w a y i n w h i c h t h e y c a n p r o t e c t t h e m s e l v e s i s
b y i n v e s t i n g i n g e n e r a l h u m a n c a p i t a l i n o r d e r t o li m i t th e i r e x p o s u r e t o r e s tr u c t u r -
i n g - d e c i s i o n s t a k e n b y o u t s i d e r s (i .e . k e e p i n g t h e i r o p t i o n s o p e n o n t h e m a n a g e r i a l
5 For academ ics, research is usually a non-institution specific activity, whereas teaching skills are
more institution specific.
6 I am grateful to R obert Heinkel for this interpretation.
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E. Maug Journal of Corporate Finance 3 (1997) 113 139 119
2. 3. 4. 5.
I I I I t P o e
O w n er s deter mine Ma nage r choose s Sta te o f natu r e s Par ty in con t r o l Payof ts ). ,, r ea l ized ;
gover na nce s t r uctu r e : speci f ic i ty o f r evealed decides abou t par t ies paid accor d ing to
cap i la l s t r uclu r e hum an cap i ta l h p r o ject c losur e con t r acts ; mana ger s
man ager ia l con t r act paid ,u ( y , )
d e c i s i o n m a k i n g r i g h t s
Fig. 1.
l a b o u r m a r k e t ) . T h i s w i ll , h o w e v e r , m a k e t h e p r o j e c t l e ss s u c c e s sf u l . M o r e o v e r ,
c o n d i t i o n ( i v ) e n s u r e s t h a t t h e r e s t r u c t u r i n g g a i n i s s u f f i c ie n t l y i m p o r t a n t r e l a t i v e
t o p o t en t ia l e f f i c i e n c y - g a i n s f r o m h u m a n c a p i ta l i n v e s t m e n t s t o m a k e c l o su r e i n
s t a te B a l w a y s a t t r a c t i v e . T h e t i m i n g o f t h e m o d e l i s d i s p l a y e d i n F i g . 1.
T h e n e x t p r o p o s i t i o n d e r i v e s t h e f i r s t- b e s t a l l o c a t io n ( l * , h * ) a s a b e n c h m a r k
f o r f u rt h e r r e s ul t s . I t i s d e f i n e d f r o m t h e m a x i m a n d :
m a x 1I = ~ p , ( h ) y., - P ( l ) D ( h ) . ( 2 )
{ I ,h } s ~ { H , M , B }
R e c a l l t h a t P ( 1 ) d e n o t e s t h e p r o b a b i l i t y o f re d e p l o y i n g t h e a s se t s u n d e r p o l i c y
I. T h e f ir s t t e r m g i v e s p r o fi t s a s a f u n c t i o n o f h a n d f o l l o w s i m m e d i a t e l y f r o m
A s s u m p t i o n 1. T h e s e c o n d t e r m i s t h e e x p e c t e d d i s u t i l i t y m a n a g e r s s u f f e r ( cf . E q .
( 1 )) . T h i s o b j e c t i v e c a n b e i n t e r p re t e d a s t h e p r o f i t - m a x i m i z a t i o n - p r o b l e m o f a n
o w n e r u n d e r t h e a s s u m p t i o n t h a t h a n d / a r e c o n t r a c t i b l e a t s t a ge 1. T h e f o l l o w i n g
p r o p o s i t i o n c h a r a c t e r i z e s t h e fi r s t - b e st , w h e r e h * d e n o t e s t h e f ir s t -b e s t i n v e s t m e n t
i n p r o j e c t - s p e c i f i c h u m a n c a p i t al : 7
Proposition 1 (Firs t-best ). The solution of prog ram (2) which characterizes the
first -best is to liquidate a project if and only if it is in state B. The firs t-bes t value
h* E (0 , 1 ) is inter ior and unique and soh, es:
p~( h )( x H - x M) -p aD '( h* ) = 0 . ( 3 )
I a s s u m e t h r o u g h o u t t h e p a p e r t h a t w e a l t h - c o n s t r a i n t s a re s u f f i c i e n t l y s e v e r e
s u c h t h a t o u t s i d e f i n a n c e is r e q u i r e d a n d c o n t r o l h a s t o b e d e l e g a te d . I a l s o a s s u m e
t h a t h i s n o t c o n t r a c t i b l e . T h i s i n t r o d u c e s a d i f f e r e n c e b e t w e e n t h e ex ante
o b j e c t i v e ( 2 ) , a n d t h e ex post p e r s p e c t i v e w h e r e o u t s i d e rs h a v e a n i n c e n t i v e to
d i s re g a r d m a n a g e r s ' i n v e s t m e n t in h u m a n c a p i ta l .
7 All proofs are available in the long version o f this paper and are not included here to econom ize on
space. The lu l l version of the paper can be downloaded from the web page 'h t tp : / /w w w. du ke .ed u/ ~
maug/research/boarddir/ ' . You can also obtain a hardcopy from the author upon request. Please see
title page for mailing address.
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1 2 0
E . M a u g / J o u r n a l ( ~f O ~ r p o r a t e F i n a n c e 3 ( 1 9 9 7 ) 1 1 3 1 3 9
4 . A n a l y s is o f a lt e r n a t i v e o r g a n i z a t i o n a l f o r m s
T h e q u e s t i o n o f w h i c h o r g a n i z a t i o n a l f o r m i s o p t im a l i s a n a l y z e d i n t h e
r e m a i n d e r o f t h is p a p e r . T h e b a s i c d i s ti n c t i o n h e r e is b e t w e e n m a n a g e r s a n d
o u t s i d e r s . M a n a g e r s a r e i n c o n t r o l a n d b y v i rt u e o f th e i r i n v o l v e m e n t i n t he
o p e r a t i o n s o f t he f i r m h a v e s u f f i c i e n t i n f o r m a t i o n t o i d e n t i f y a n y r e s t r u c t u r i n g
p o t e n t i a l t o i n c r e a s e s h a r e h o l d e r v a l u e . A l t e r u a t i v e l y , o u t s i d e p a r t i e s c a n b e g i v e n
c o n t r o l r i g h t s , b u t a n y o u t s i d e r o t h e r t h a n t h e i n c u m b e n t m a n a g e m e n t n e e d s t o
a c q u i r e a d d i t i o n a l c o s t l y i n f o r m a t i o n i n o r d e r t o r e a l i z e t h e r e s t r u c t u r i n g p o t e n t i a l
o f t h e f i r m :
A s s u m p t i o n 3 ( R e s t r u c t u r i n g b [ b r m a t i o n ). A n o u t s i d e p a r t y c a n r e a l i z e t h e
r e s t r u c t u r i n g p o t e n t i a l o f t h e f i r m o n l y i f it h a s i n v e s t e d i n a d d i ti o n a l i n f o r m a t i o n .
T h i s i n f o r m a t i o n i s o b t a i n e d w i t h p r o b a b i l i t y T . i n f o r m a t i o n a c q u i s i t i o n i s c o s t l y
w i t h i n f o r m a t i o n a c q u i s i t i o n c o s t s C (~ -). T h e c o s t f u n c t i o n s a ti s fi e s C ' ( ~ - ) > 0 ,
C " ( - r ) > 0 and C ( 0 ) = 0 . M a n a g e r s o b s e r v e t h is i n f o r m a t i o n w i t h o u t i n c u rr i n g a n y
a d d i t i o n a l c o s t s .
N o t e t ha t st a te s i s s ti ll a s s u m e d t o b e c o m m o n k n o w l e d g e . H o w e v e r , i n o r d e r
t o r e a l i z e t h e d i f f e r e n c e L , - x , . , m o r e d e t a il e d o p e r a t i n g k n o w l e d g e o f th e f i r m i s
r e q u i r e d . W h e r e a s m a n a g e r s , w h o o p e r a t e t h e f ir m o n a d a y t o d a y b a s i s a re
a s s u m e d t o p o s se s s t h is k n o w l e d g e , a n y o u t si d e p a r t y w h o w a n t s t o i m p r o v e t h e
o p e r a t i o n s o f th e f i r m h a s t o a c q u i re it. E a c h o r g a n i z a t i o n a l s t r u c t u r e m u s t
d e t e r m i n e t w o e l e m e n t s : m a n a g e r i a l c o m p e n s a t i o n a n d t h e i m p l i e d c l o s u r e p o l i c y ,
w h i c h d e p e n d s a l s o o n t h e i n c e n t i v e s o f o u t s i d e r s t o a c q u i r e i n f o r m a t i o n . O r g a n i -
z a t i o n a l f o r m s a r e c h a r a c t e r i z e d a s f o l l o w s :
M a n a g e r i a l c o n t r o l
D i r e c t o r s
D e b t
T a k e o v e r s
M a n a g e r s ' c o m p e n s a t i o n c o n t r a c t is f i x e d b y t h e in i ti a l o r g a -
n i z a t i o n a l d e s i g n e r a n d o n l y m a n a g e r s h a v e c o n t r o l o v e r
c l o s u r e . ( S e c t i o n 4 . 1 )
M a n a g e r s d e c i d e o n c l o s u r e p o l i c y ; d i r e c t o r s h a v e c o n t r o l
o v e r m a n a g e r i a l r e m u n e r a t i o n a n d c a n u s e t h is t o a f f e c t
c l o s u r e - p o l i c y . ( S e c t i o n 4 . 2 )
I f t h e f i rm is s o lv e n t , o n l y m a n a g e r s h a v e c o n t r o l . I n
b a n k r u p t c y s t a t e s o n l y d e b t h o l d e r s h a v e c o n t r o l o v e r t h e
a s s e t s . D e b t h o l d e r s d o n o t g e t i n v o l v e d i n d e t e r m i n i n g m a n -
a g e r i a l p a y . ( S e c t i o n 4 . 3 )
A t a k e o v e r r a i d e r c a n a c q u i r e c o n t r o l o f th e a s s e t s o f th e f i r m
a n d c a n o f f e r m a n a g e r s s e v e r a n c e p a y m e n t s . ( S e c t i o n 4 . 4 )
E a c h o f t h e s e o r g a n i z a t i o n a l f o r m s i s a n a l y z e d a s a n a l t e r a ti o n o f s ta g e 4 o f th e
e x t e n s i v e f o r m o f t h e g a m e ( c f. F i g . 1 ).
, i , ~ I i , , i T l ' r l I ,
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E . M a u g / J o u r n a l ( ? [' Co rp or at e F i n a n c e 3 ( 1 9 9 7 ) 1 13 1 3 9 121
4 . 1. E x p l i c i t c o n t r a c t u a l p r o t e c t io n : P u r e m a n a g e r i a l c o n t r o l
P u r e m a n a g e r i a l c o n t r o l is t he s i m p l e s t o r g a n i z a t io n a l f o rm a n d r e s e m b l e s a
c l a s s i c a l p r i n c i p a l - a g e n t s i t u a t i o n , M a n a g e r s a r e f u l l y p r o t e c t e d b y a n e x p l i c i t
c o n t r a c t s i n c e t h e y e x e r c i s e a l l c o n t r o l r ig h t s o v e r t h e u s e o f th e a s s e t s . T h e n t h e
o n l y w a y t o o b t a i n t h e g a i n s f r o m r e s t r u c t u r i n g i s a c o m p e n s a t i o n - s c h e m e t h a t
g i v e s m a n a g e r s a n i n c e n t i v e t o c l o s e t h e p r o j e c t i n t h e l o w s t a t e . M a n a g e r s '
c o m p e n s a t i o n c a n b e a n y p r o f i t c o n t i n g e n t c o n tr a c t / z (y s ) . M a n a g e r s h a v e z e r o
i n i ti a l w e a l t h s o t h a t th e c o n t r a c t c a n n o t i n v o l v e n e g a t i v e p a y m e n t s i n a n y s t a te ,
i .e . / ~ ( y ~ ) > = 0 f o r a l l y ~,. S i n c e m a n a g e r s h a v e n o w e a l t h t h e y w i l l n o t b e m a d e
r e s i d u a l c l a i m a n t s ; s i n c e t h e y a r e r i s k n e u t r a l t h i s m u s t b e r u l e d o u t , o t h e r w i s e t h e
s o l u t i o n o f th e p r o b l e m w o u l d b e t r i v i a l. D e n o t e b y h E t h e d e g r e e o f s p e c i f i c i t y o f
h u m a n c a p i t a l f o r t h e c a s e o f e x p l i c i t c o n t r a c t u a l c o v e n a n t s , a n d b y r t h e r en t
m a n a g e r s e x t r a c t , d e f i n e d a s t h e d i f f e r e n c e b e t w e e n t h e i r e x p e c t e d u t i l i t y a n d t h e i r
r e s e r v a t i o n u t i l i t y , a s s u m e d t o b e z e r o .
P r o p o s i t i o n 2 ( P u r e m a n a g e r i a l c o n t r o l ) . ( i ) T h e o p t i m a l m a n a g e r i a l c o n t r a c t
u n d e r p u r e m a n a g e r i a l c o n t ro l h a s :
{ ~
h E )
if y.~ = LB.
/ ~ (y ~ ) = ( X H ) > 0 i f y , = X u . ( 4 )
i f y.~ 4= L B , x , ,
w h e r e 0 < I~ ( X # ) < x ~ - x g . i ~ ( x H ) a n d hF, s a t i s ~ :
~ ( x u ) p ' ( h E ) = p e D ' ( h F )
( 5 )
f r o m m a n a g e r s ' f i r s t - o r d e r c o n d i ti o n s . T h i s i n d u c e s r e st r u c tu r i n g i [ a n d o n l y ( f
s = B a n d u n d e r i n v e s t m e n t i n p r o j e c t - s p e c if i c h u m a n c a p it a l: h E < h * .
( i i ) M a n a g e r s o b t a i n a s t r ic t l y p o s i t i v e r e n t :
r = I ~ ( x H ) P H ( h E ) .
( 6 )
H e n c e , t h e o p t i m a l c o n t r a c t c o m p r i s e s ( 1 ) a s e v e r a n c e p a y m e n t i n c a s e o f
l i q u i d a t i o n ( a ' g o l d e n p a r a c h u t e ' ) , a n d ( 2 ) a b o n u s p a y m e n t i n t h e h ig h s t a t e H .
T h e l a tt e r c o u l d b e i m p l e m e n t e d t h r o u g h a s t o c k o p t i o n s c h e m e w i t h e x e r c is e
p r i c e X e q u a l t o M a x ( L B , x M ) a n d g r a n t i n g t ~ ( X H ) / ( X H - - X ) o p t i o n s . / ~ ( Z ~ ) i s
p o s i t i v e i f i t i n d u c e s t h e m a n a g e r e i t h e r t o c l o s e t h e p r o j e c t o r to i n v e s t i n m o r e
s p e c i f i c h u m a n c a p i t a l . I t f o l l o w s f r o m A s s u m p t i o n 2 t h a t l iq u i d a t i o n i s o p t i m a l
w h e n e v e r s =
B ,
h e n c e t h e m a n a g e r i s p a i d f o r l i q u i d a t i n g i n t h i s s t a t e . A n
i n c r e m e n t a l i n c r e a s e i n h i n c r e a s e s p r o f it s b y
p ' u ( h ) ( x H - x M )
f r o m A s s u m p t i o n
1 , s o t h a t p r o f i t s h a r i n g i n s t a te s = H b e n e f i t s i n i t i a l o w n e r s ; n e v e r t h e l e s s ,
m a n a g e r s a r e n o t m a d e r e s i d u a l c l a i m a n t s , o t h e r w i s e o w n e r s w o u l d s u r r e n d e r a l l
b e n e f i t s t o t h e m , s o t h a t / ,z ( x
n ) < x H - x g
a n d h E < h * . S i n c e m a n a g e r s h a v e n o
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122 E. M au g / Jou rna l (~["Corporate Fin ance 3 (1997) 113 -13 9
r e s o u r c e s , t h e y c a n n o t p a y f o r t h e v a l u e o f t h i s s h a r e a n d o b t a i n a re n t . I n v i e w o f
P r o p o s i t i o n 2 , p r o f i t s / / F i n t h e c a s e o f p u r e m a n a g e r i a l c o n t r o l a re :
/ / F ~ = y ' p ~ ( h e ) x ., + p ~ ( L ,~ - x B ) - r . ( 7 )
.s
H e n c e , i n s e t ti n g / x ( x H ) o w n e r s t r ad e o f f t h e b e n e f i t f r o m h i g h e r p r o f i ts o f th e
f i rm a g a i n s t t he r e n t s th e y h a v e t o p a y m a n a g e r s i n o r d e r t o i m p l e m e n t a c e r ta i n
v a l u e f o r h . S i n c e t h e s e r e n t s i n c r e a s e i n h , a s u b o p t i m a l v a l u e h e < h * i s c h o s e n .
T h e w e a k n e s s o f p r o t e c t i n g m a n a g e r s b y e x p l i c i t c o n t r a c t s is t h a t m a n a g e r s d o n o t
s i gn a n e m p l o y m e n t c o n t ra c t c o n t i n g e n t on h a n d h a v e t o b e m o t i v a t e d b y a b o n u s
p a y m e n t ~ ( x , ) i n t h e h i g h st at e. T h e n e x t s e c t i o n i n t r o d u c e s a n o w n e r s h i p - s t r u c -
t u r e w h i c h p o t e n t i a l l y o v e r c o m e s t h i s p r o b l e m .
4 .2 . I n d e p e n d e n t d i r e c t o r s
T h i s o w n e r s h i p - s t r u c t u r e i n t r o d u c e s a n o t h e r a g e n t w h i c h I c a l l a s u p e r v i s o r y
b o a r d o f d i re c t o r s o r s i m p l y i n d e p e n d e n t d ir e c to r s . F o r t h e p u r p o s e o f t h is
a r g u m e n t i t i s i m m a t e r i a l w h e t h e r i n d e p e n d e n t d i re c t o r s a r e a p a r t o f a u n i t a r y
b o a r d , o r f o r m a se p a r a t e s u p e r v i s o r y b o a r d i n a tw o - t i e r s y s t e m , s U n l i k e
m a n a g e r s , d i r e c to r s d o n o t i n v e s t i ll f i r m - s p e c i f i c h u m a n c a p i ta l , b u t t h e y h a v e t o
b e m o t i v a t e d t o a c q u i r e i n f o r m a t i o n a b o u t a l t e r n a t iv e o p e r a t i n g p o l ic i e s a c c o r d i n g
t o A s s u m p t i o n 3 . D i re c t o rs m a x i m i z e e x p e c t ed u t i li ty . T h e i r c o m p e n s a t i o n - s c h e m e s
m u s t b e l i n e a r p a y m e n t s w h i c h m a y b e c o n t i n g e n t o n t h e n e t p r o fi t s o f t h e f ir m n e t
o f m a n a g e r s ' c o m p e n s a t i o n . T h e y n m s t b e o f t h e fo r m
7 ( Y , - # ( Y . ~ )) ( 8 )
L i k e m a n a g e r s , d i r e c t o rs h a v e n o i n i t ia l w e a l t h , h e n c e t h e y c a n n o t p a y f o r t h e i r
s h a re s o u t o f t h e ir o w n w e a l t h . 9 D i r e c t o r s ' m o t i v a t i o n c a n b e u n d e r s t o o d i n t h r e e
w a y s . F i r s t, t h e y m a y b e o b l i g e d t o h o l d y s h a r e s o f t h e f i rm w h i c h e n t i t le s th e m
t o a f r a c t i o n 7 i n t h e d i v i d e n d y.~ - / , ( y , ). m S e c o n d , t h e y m a y b e u n d e r a
f i d u c i a r y d u t y t o s h a r e h o l d e r s t o a c t o n t h e i r b e h a l f . I n t h is c o n t e x t s u c h a d u t y
w o u l d o b l i g e t h e m t o m a x i m i z e t o t al p a y o u t s . L a s t, t h e y m a y w a n t t o a c q u i r e a
g o o d r e p u t a t i o n a s i n d e p e n d e n t m o n i t o r s i n o r d e r to g a i n m o r e d i r e c to r s h i p s i n th e
f u t u re . ~t T h e m o d e l l i n g a p p r o a c h h e r e r e l ie s e x c l u s i v e l y o n t h e m o t i v a t i o n o f
d i r e c to r s t h r o u g h s h a r e h o l d i n g s o r i n c e n t i v e c o n t r a c t s c o n f o r m i n g to (8 ). W h e r e a s
s One might argue that separate supervisory boards are more likely to be independent. See Monks
and Minow (1995) for a textbook treatment of corporate governance institutions.
9 Situations where directors are or represent lar ge shareholders would have to be co vered b y a
different analysis. The discussion here refers to the typical situation of externally appointed directors
whose wealth is small relative to the size of the firm.
10 Cf. L inn and M artin (1994) for an em pirical documen tation of the stoc k ownership o f directors.
ii Cf. Fama (1980) for a detailed exposition of this hypothesis and Kaplan and Reishus (1990) and
Gilson (1990) for supporting empirical evidence.
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a l l t h r e e a p p r o a c h e s i m p l y t h a t d i r e c t o r s ' i n c e n t i v e s w i l l b e a l i g n e d w i t h t h o s e o f
s h a r e h o l d e r s , o n l y t h e g r a n t i n g o f f r e e s h a r e s t o d i r e c t o r s i m p l i e s t h a t t h i s c o m e s a t
a d i r e c t c o s t t o i n i t i a l s h a r e h o l d e r s , m o t i v a t i n g t h e d o u b l e a g e n c y p r o b l e m
a n a l y z e d h e r e . T h e a s s u m p t i o n o n l i n e a r i t y i s a s i m p l i f i c a t i o n . I t w i l l b e s h o w n
b e l o w ( S e c t i o n 4 . 3 ) t h a t g r a n t i n g d i r e c t o r s o p t i o n s o r l e v e r i n g t h e f i r m w o u l d
i m p r o v e t h e a l l o c a t i o n . H o w e v e r , l i n e a r i t y d o e s n o t a f f e c t a n y o f t h e q u a l i t a t i v e
i n s i g h t s d i s c u s s e d i n t h i s s e c t i o n .
U n d e r t h i s o w n e r s h i p - s t ru c t u r e , m a n a g e r s h a v e t h e r i g h t to d e c i d e a b o u t t h e u s e
o f th e a s s e t s . D i r e c t o r s h a v e t h e r i g h t to r e v i e w m a n a g e r s ' s a l a r ie s . F o r c l a r i ty ,
d e n o t e t h e o r i g i n a l m a n a g e r i a l c o n t r a c t a g r e e d a t s ta g e 1 b y i~o(Z,) a n d t h e
c o m p e n s a t i o n o f f e r e d b y d i r e c to r s b y /2 . D i r e c t o r s c a n i n f l u e n c e c l o s u r e d e c i s io n s
b y o f f e r i n g m a n a g e r s a d d i t i o n a l c o m p e n s a t i o n f o r d i v e s t i n g . H e n c e , m a n a g e r s
n e g o t i a t e w i t h d i r e c to r s o v e r t h e c l o s u r e d e c is i o n a n d o v e r a d e q u a t e c o m p e n s a t i o n .
4.2.1. Full control by independent directors
T h e m a i n t a i n e d a s s u m p t i o n o f t h is s u b s e c t i o n ( t o b e r e l a x e d b e l o w ) i s t h a t
d i r e c t o r s h a v e a l l t h e b a r g a i n i n g p o w e r w h e n t h e y n e g o t i a t e m a n a g e r s ' c o m p e n s a -
t i o n . W h e n e v e r d i r e c t o r s w a n t t o r e d e p l o y a s s e t s t h e y o f f e r m a n a g e r s a c o m p e n s a -
t i o n / 2 i n r e t u r n f o r t h e i r c o n s e n t t o t h i s d e c i s i o n . T h e e x t e n s i v e f o r m o f s t a g e 4
( s e e F ig . 1 a b o v e ) i s th e n t h e f o l l o w i n g s t y l iz e d b a r g a i n i n g g a m e :
( a ) D i r e c t o r s o f f e r m a n a g e r s a c o m p e n s a t i o n /2 s u b j e c t t o t h e i r c o n s e n t to a s se t
r e a l l o c a t i o n s .
( b ) M a n a g e r s a c c e p t o r r e j e c t t h i s o f f e r .
( c ) I f t h e y re j ec t , t h e o r ig i n a l m a n a g e r i a l c o n t r a c t is i m p l e m e n t e d , m a n a g e r s
r e c e i v e ~ 0 (Y ~ ) a n d n o a s s e t c a n b e s o l d . I f t h e y a c c e p t , t h e y r e c e i v e /2 a n d
d i r e c t o r s d e c i d e w h e t h e r t o l i q u i d a t e o r n o t .
T h e f i r m i s f u l l y e q u i t y f i n a n c e d , b u t e q u i t y h o l d e r s h a v e n o d e c i s i o n m a k i n g
r i g h t s o t h e r t h a n t h e i n it i al a p p o i n t m e n t o f d i r e c to r s . P r o p o s i t i o n 3 d e s c r i b e s t h e
a l l o c a t i o n .
Propositi on 3 (Direct ors). Assum e control is delegated to managers and direc-
tors. Di rectors can identiD restructuring possibilit ies at a cost as defined in
Assumption 3. They retain all bargaining power in negotiations with management,
but managers have a veto right over the use of the assets. Then:
(i) Directors hold a frac tion t~D of the equity and identify the restructuring
potential o f the fir m with probabili ty rD. If director s are informed, mana gers
receive a trans fer /2 = D( h* ) in state s -- B and zero transfers in the other two
states. There are no prof it-c ontingen t payments, i.e. /~0(Y~) = 0 .for all Z,. The
optimal values rD and YD are unique and related as
YD = ps ( L 8 _ x8 _ D( hD) ) ( 9 )
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124
E. Maug /Journal ~[ Colporate Finance 3 (1997) 113-139
T h e s p e c i fi c i ~ , o f h u m a n c a p i t a l h t~ a n d t h e s et ~ e ra n c e p a y m e n t t o m a n a g e r s
D( hl> ) a re d ec re as in g in ~-L~, a nd "rt> is in c re as ing in YD.
( i i ) I f
C ' ( I )
a n d
C ( 1 )
a r e s m a l l a n d PB l a r g e e n o u g h , t h is m e c h a n i s m
i m p l e m e n t s t h e f i r s t - b e s t a l l oc a t i on w i t h h o = h * . I f C '( ~ 't ~) i s s u f f i c i e n t l y l a r g e
a n d p e s u f f ic i e n t ly s m a l l, t h e n t h i s m e c h a n i s m l e a d s t o a l o w e r e x a n t e pa y o ff " t o
i n it ia l s h a r e h o l d e r s t h a n p u r e m a n a g e r i a l c o n t r o l.
S t a n d a r d b a r g a i n i n g t h e o r y i m p l i e s t h a t d i r e c t o r s w i l l o f f e r m a n a g e r s a l w a y s
e x a c t l y D ( h ) i f t h e y p r o p o s e t o c l o s e t h e p r o j e c t , s o t h at t h e n e t e c o n o m i c g a i n
f r o m c l o s u r e , L R - x B - D ( h ) a c c r u e s e n t i r e l y t o s h a r e h o l d e r s , w h e r e a s m a n a g e r s '
u t i l it y r e m a i n s u n c h a n g e d t h r o u g h b a r g a i n i n g a n d i s u n a f f e c t e d b y c lo s u r e .
T h e r e f o r e , d i r e c t o r s c h o o s e t h e l iq u i d a t i o n p o l i c y w h i c h m a x i m i z e s t h e n e t g a i n ,
a n d m a n a g e r s ' s e v e r a n c e p a y m e n t a l w a y s e x a c t l y o f fs e t s th e i r u t i l i ty - l o s s i f t h e
p r o j e c t i s c l o s e d , t h e r e b y g i v i n g t h e m f u l l i n s u r a n c e a g a i n s t e x p r o p r i a t i o n . A s a
r e s u l t, t h e l i k e l i h o o d o f th e c l o s u r e d e c i s i o n h a s n o i m p a c t o n t h e i r d e c i s i o n t o
i n v e s t i n s p e c i fi c h u m a n c a p i t a l , a n d t h e y c a n i n v e s t th e e q u i l i b r i u m a m o u n t ht~
w i t h o u t a p o s it i v e b o n u s p a y m e n t . O n e w a y o f im p l e m e n t i n g s u c h a n e g o t i a ti o n
g a m e w o u l d h a v e o n e i n d e p e n d e n t d i r e c t o r le s s th a n t h e n u m b e r o f v o t es r e q u i re d
t o d e c i d e o n a s s e t s a l es . O b s e r v e t h a t d ir e c t o r s a c t a s a g e n t s o f s h a r e h o l d e r s i n t h a t
t h e y m a x i m i z e e x a n t e s h a r e h o l d e r w e a l t h . E x p o s t , s h a r e h o l d e r s w o u l d p r e f e r t o
r e n e g e o n t h e c o n t r a c t a n d c l o s e i n s t a t e s = M a s w e l l .
H o w e v e r , t h e b e n e f i t s o f r e s t ru c t u r i n g c o m e a t a c o s t to s h a r e h o l d e r s , s i n c e
t h e y h a v e t o m o t i v a t e d i r e c t o r s t o b e c o m e i n f o r m e d . F r o m E q . (9 ) , t h e k e y
v a r i a b l e i s t h e
m a r g i n a l
c o s t o f i n f o r m a t i o n , s i n c e t h i s d e t e r m i n e s t h e d e g r e e t o
w h i c h d i r e c t o r s b e c o m e i n f o r m e d f o r a g i v e n f ra c t i o n o f t h e e q u i t y t h e y h o l d . I f
t h e m a r g i n a l c o s t f o r b e c o m i n g i n f o r m e d i s r e l a t i v e l y m o d e s t , t h e n y ~ a n d t h e
c o s t s t o s h a r e h o l d e r s , w h i c h a r e YD ~ , P.~ Y .~, a r e l o w e n o u g h , s o t h a t d i r e c t o r s w i l l
b e g i v e n i n c e n t i v e s to b e c o m e p e r f e c t l y i n f o r m e d ( T = 1). T h i s r e q u i r e s a l s o th a t
t h e c o s t f u n c t i o n i s n o t t o o c o n v e x ( C ( h ) i s sm a l l ) , s i n c e t he e x a n t e t r a d e o f f is
b e t w e e n a n i n c r e m e n t a l i n c r e a s e i n ~- a n d t h e b e n e f i t s o f s u p e r v i s i o n , a n d a n
i n c r e m e n t a l i n c r e a s e i n c o s t s , (i . e . a n i n c r e a s e i n y a n d t h e r e f o r e C ' ( ~ -) ) . C o n -
v e r s e l y , i f t h e c o s t s o f p r o v i d i n g d i r e c t o r s w i t h i n c e n t i v e s a r e t o o l a r g e , t h e n t h e
b e s t s o l u t io n w h i c h c a n b e a c h i e v e d w i t h t h is m e c h a n i s m i s s t il l d o m i n a t e d b y
p u r e m a n a g e r i a l c o n t ro l . W h e r e a s s h a r e h o l d e r s p a y t h e c o s t s o f c o n t r o l t h r o u g h
d i r e c t o r s i n a l l st a te s o f t h e w o r l d , t h e y o b t a i n t h e b e n e f i ts o n l y i n th e b a d s t a te
s = B . H e n c e , d i r e c t o r s b e c o m e m o r e a d v a n t a g e o u s i f PH i s l a r g e r. A l s o , i f
d i r e c t o r s h a v e s t r o n g e r i n c e n t i v e s , t h e n ( 1 ) t h e i n c i d e n c e o f r e s t ru c t u r i n g i n c r e a s e s
b e c a u s e ~- i n c r e a s e s , a n d t h e r e f o r e ( 2 ) t h e i n v e s t m e n t i n s p e c i f i c h u m a n c a p i t a l b y
t h e m a n a g e r i s r e d u c e d . ~-~
12 This result is related to the entrenchment argument by Shleifer and Vishny (1989). However, here
managers respond to the possible breach of implicit contracts. There is no sense in which they actively
entrench themselves by making themselves indispensable.
. . . . . . T . . . . . . . . T . . . . . . .
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E. Ma ug / Journa l o[' Corporate Fina nce 3 (1997 ) 113-13 9 125
The first-best result is somewhat special but instructive, since it reveals the
essential elements of the dire ctor-mechanis m very clearly. In order to understand
better the distinctive features of the director-mechanism and the importance of
negotiation, compare directors with any randomly chosen large shareholder who
owns a share o- of the firm and has the right to trigger liquid ation of the project
but is not allowed to change managers' remuneration. Managers are protected by a
severance package which gives them a golden parachute G if they are dismissed.
This setup is similar to the direct or-me chani sm except that the negotia tion elem ent
is removed. This leads to the following:
P r o p o s it io n 4 ( R a n d o m sh a r e h o l d e r ) . A s s u m e a r a n d o m l y c h o s e n s h a r e h o l d e r
o w n s a s h a r e o" o f t h e f i r m a n d h a s t h e r i g h t to i n it ia t e l i q u id a t i o n a n d m a n a g e r s
h a t ,e a s e t~ e ra n c e p a c k a g e w h i c h p a y s t h e m a g o l d e n p a r a c h u t e G ~ f t h e y a r e
d i s m i s se d . T h e n t h e a ll o c a t io n c a n b e i m p r o~ , ed f o r a l l p o s s i b l e p a r a m e t e r s b y
a l s o g i l d i n g t h i s s h a r e h o l d e r t h e r i g h t t o r e n e g o t i a t e m a n a g e r i a l c o m p e n s a t i o n .
Note that this result does not assume that the golden parachute G and the stake
of the random shareholder cr are in any sense optimally chosen. This result
illuminates why directors' discretion over managers ' severance package, and
hence the negotiation aspect of the director-mechanism is crucial: it makes
severance pay c onti ngent on h, so that the allocation is dependent on the
non-contractabl e variable h. A managerial contract which automatically grants an
ex ante fixed severance payment in case of dismissal cannot replace this since it
replaces a payme nt which is conti ngen t on h by one which is not. This phe-
nomenon is familiar from the literature on the hold-up problem. 13
Note that several assumptions about directors are important for the result to
obtain which define a director as an i nstitution which com bines elements of
managers and elements of ordinary shareholders. They are similar to shareholders
in that they aim to increase pecuniary payoffs to shareholders only. 14 They are
different from shareholders because they are conferred additional property rights
(determine operating decisions, managerial compensation) and they bear additional
costs to make informed decisions. Directors are different from executive manage-
ment because they have no vested interests in particular operating decisions.
Specifically, they have no specific human capital at stake in case of project
closures. This may be regarded as the d e f i n i t i o n of an independent director.
Directors whose human capital is so specialized that it gives them a stake in a
13 Cf. Hermalin and Katz (1991) for a proof of a general theorem for a principal agent contract.
Aghion et al. (1994) and Hart and Moore (1995) discuss alternative renegotiation settings and the
implicationsfor the underinvestment roblem. Other contributions nclude Hubermanand Kahn (1988),
Chung (1991) and MacLeod and Malcomson(1993).
14 Byrd and Hickman (1991) and Linn and Martin (1994) find that shareholdings of independent
directors increase the performance of corporate boards.
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1 2 6 E. Ma u g / Jo u rn a l ~ / ' C o rpo ra te F in a n ce 3 (1 9 9 7 ) 1 1 3-1 39
p a r t i c u l a r d e c i s i o n a r e n o t i n d e p e n d e n t a n d s h o u l d b e c l a s s e d a s e x e c u t i v e
m a n a g e m e n t . D i r e c t o r s w h o a r e r e p r e s e n t a t i v e s o f a f f i li a t e d c o m p a n i e s a r e a l s o
n o t i n d e p e n d e n t i n t h e s e n s e r e q u i r e d ( s e e S e c t i o n 4 . 2 . 2 b e l o w ) . L a s t l y , d i r e c t o r s
a r e a s s u m e d t o h a v e a l l t h e n e g o t i a t i n g p o w e r v i s a v i s m a n a g e r s . T h i s i s a s t r o n g
a s s u m p t i o n a n d i ts r e l a x a t io n i s t h e s u b j e c t o f t h e n e x t s e c t io n .
4.2 .2 . Manager ia l negot ia t ing power
T h e p o s i t i v e r e s u lt a b o u t i m p l e m e n t a t i o n o f th e f i rs t - b e s t w i th t h e d i r e c t o r -
m e c h a n i s m i s o b v i o u s l y e x t r e m e a s i t d e p e n d s o n a l l b a r g a i n i n g - p o w e r b e i n g
g i v e n t o d i r e c to r s . H o w e v e r , a s d i r e c t o r s n e e d m a n a g e r s ' c o n s e n t i n o r d e r t o f o r c e
r e s t r u c t u r in g a n d b e c a u s e t h e y h a v e t o r e n e g o t i a te t h e i r s al a ry , m a n a g e r s m a y b e
t o s o m e d e g r e e s u c c e s s f u l i n p r e s s i n g f o r a h i g h e r c o m p e n s a t i o n t h a n i s n e e d e d t o
m a k e t h e m j u s t i n d i f f e r e n t b e t w e e n c o n t i n u a t i o n a n d c l o s u r e o f t h e p r o j e c t . T h i s
s e c t i o n t h e r e f o r e a n a l y z e s t h e s a m e o w n e r s h i p - s t r u c t u r e a s t h e p r e v i o u s s e c t i o n
u n d e r a l t e r n a t i v e a s s u m p t i o n s o n b a r g a i n i n g p o w e r . H e n c e , t h e e x t e n s i v e f o r m o f
s t a g e 4 o f t h e g a m e i s n o w :
( a ) D i r e c t o r s a n d m a n a g e r s b a r g a i n o v e r t h e d e c i s i o n t o c l o s e t h e f i r m a n d o v e r
m a n a g e r s ' s a l a r y .
( b ) I f t h e y r e a c h an a g re e m e n t , m a n a g e r s r e c e iv e a t r a n s f e r / 2 a n d i m p l e m e n t t h e
a g r e e d r e s t r u c t u r i n g d e c i s i o n . I f th e y d o n o t a g r e e m a n a g e r s d e c i d e a n d
r e c e i v e t h e p a y m e n t f r o m t h e i r o r i g i n a l c o n t r a c t / ~ 0 .
15
T h e b a r g a i n i n g o u t c o m e i s d e t e r m i n e d f r o m :
A s s u m p t i o n 3 ( B a r g a i n i n g ) . I f m a n a g e r s a n d d i r e c t o rs e n t e r a b a r g a i n i n g g a m e
a t s t a g e 4 , t h e n t h e o u t c o m e i s d e t e r m i n e d a c c o r d i n g t o a g e n e r a l i z e d N a s h -
b a r g a i n i n g s o l u t i o n w h i c h g i v e s d i r e c t o r s b a r g a i n i n g - p o w e r 1 - ce a n d m a n a g e r s
b a r g a i n i n g - p o w e r c ~ .
I t i s a l m o s t i m p o s s i b l e t o p r e s c r i b e i n a n y k i n d o f e x p l i c i t c o n t r a c t t h e
b a r g a i n i n g - p o s i t i o n s o f i n s i d e rs w h o w o r k i n c l o s e r e l a t io n s h i p s , l et a lo n e f o r m a l -
i z e s u c h a b a r g a i n i n g - p r o c e s s . T h e a p p r o a c h a d v o c a t e d h e r e is t o t a k e ' b a r g a i n i n g
p o w e r ' a s e x o g e n o u s l y g i v e n r a t h er t h a n t o m a k e i t p a r t o f t h e f o rm a l m o d e l .
R e s e a r c h e r s o f c o rp o r a t e g o v e r n a n c e h a v e a n a l y z e d d e t e rm i n a n t s o f th e r e la t iv e
p o s i t i o n s o f d i re c t o r s v e r s u s e x e c u t i v e s . L o r s c h a n d M c I v e r ( 1 9 8 9 ) i d e n t i f y in
p a r t i c u l a r ( 1 ) t h e n o m i n a t i o n p r o c e s s o f d i r e c t o r s ( s e l e c t e d b y t h e C E O o r an
i n d e p e n d e n t c o m m i t t e e ) , ( 2 ) t h e i r l e g a l a c c o u n t a b i l i t y , a n d ( 3 ) t h e i r a c c e s s t o
15 F o r a t e x t b o o k t r e a t m e n t o f th e g e n e r a l i z e d N a s h b a r g a i n i n g - s o l u t i o n s e e B i n m o r e ( 1 9 9 2 , c h . 5 ) .
T h e c o o p e r a t i v e s o l u t io n c h o s e n h e r e i s d i r e c tl y r e l a te d t o n o n - c o o p e r a t i v e b a r g a i n i n g s o l u t io n s a n d t h e
s o l u t io n b e l o w h a s a n i n t e rp r e t a ti o n i n t e r n ls o f a l t e r n a t i n g o f fe r g a m e s ; c f . O s b o r n e a n d R u b i n s t e i n
( 1 9 9 0 , c h . 4 ) f o r a d i s c u s s i o n .
.... T ~' ~ - - ~ ~'~r - 't -*
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E. Maug Journal ~)~Corporate Finance 3 (1997) 113 139
127
i n d e p e n d e n t i n f o r m a t i o n a l s o u r c e s . T h e l a s t a r g u m e n t w o u l d i m p l y t h a t c o s t s C ( ~ -)
a n d c~ a r e p o s i t i v e l y c o r r e l a t e d . B a y s i n g e r a n d B u t l e r ( 1 9 8 5 ) e m p h a s i z e t h e
d i f f e r e n c e b e t w e e n a f f i l i a te d o u t s i d e d i r e c t o r s w h o r e p r e s e n t o r g a n i s a t i o n s w i t h
f i n a n c i a l o r b u s i n e s s r e l a t i o n s h i p s w i t h t h e f i r m a n d i n d e p e n d e n t d i r e c t o r s . T h e y
f i n d t h a t f i r m s w i t h a s t r o n g e r i n d e p e n d e n t e l e m e n t p e r f o r m o n a v e r a g e b e t t e r . ~ 6
D i r e c t o r s r e c e i v e i n c a s e o f c l o s u r e T ( L ~ - / 2 ) a n d in c a se o f n o c lo s u r e
y(x,- txo(x,)) .
S i m i l a r l y , m a n a g e r s g e t / x0 (X ~ .) i n c a s e o f c o n t i n u a t i o n a n d
/ 2 - D ( h )
i n c a s e o f c l o s u r e . H e n c e , t h e m a x i m a n d f o r t h e g e n e r a l i z e d N a s h
B a r g a i n i n g g a m e i s
q ~ ( h , / 2 , a ) { T ( L , . x ~ / 2 + , x , ( , ,~,
- - tZol, X , ) ) j * { / 2 - / . % ( x ) - O ( h ) }
(lO)
T h e n :
/ 2 ( o ~, h ) - a r g m a x ~ p( h , / 2 , c ~ ) . ( 1 1 )
#
T h e r e s u l t i s e x p r e s s e d i n t h e f o l l o w i n g p r o p o s i t i o n .
Proposition 5 (Bargainin g Power). (i) Suppose Assumption 3 holds and man-
agers have bargaining powe r c~. Then the fir m will be closed if and only (f
directors have acqu ired information and the fi rm is in state s = B. Directors
award managers a transfer/2 contingent on c and h given by
/ 2( ce, h ) = , , , ( x s )
+ D( h) c~( L~ - x R - D( h ))
( 1 2 )
and /2 = tXo in all other states.
(ii) If c~ > O, the director-mechani sm does not imple ment the firs t-best allo-
cation anymore fo r any fo rm of C(T). The payoff to original owners is monotoni-
cally decreas ing in c~ and there exists a critical value fo r e~, ceMc with
0 < c~Mc < 1 such that the dir ector-mechan ism dominates p ure manager ial con-
trol i f 0 < c~
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128 E. Maug / Journal qf Cotporate fTnance 3 (1997) 113 139
T h e i n t u it i o n b e h i n d t h e s e c o n d p a r t o f t h e r e s u lt i s t h a t d ir e c t o r s w h o d o n o t
h a v e s u f f i c i e n t b a r g a i n i n g - p o w e r a g a i n s t m a n a g e m e n t d o n o t o n l y b e c o m e l e s s
u s e f u l , b u t p o s i t i v e l y h a r m f u l s i n c e t h e y w o r s e n m a n a g e r s ' i n c e n t i v e s t o i n v e s t i n
p r o j e c t - s p e c i f i c h u m a n c a p i t a l . T h i s i s s o m e w h a t s u r p r i s i n g b e c a u s e m a n a g e r s '
c o m p e n s a t i o n i n r e s t r u c t u r i n g - s t a t e s i n c r e a s e s w i t h t h e i r b a r g a i n i n g - p o w e r . 17
I n s p e c t i o n o f E q . (1 1 ) r e v e a l s w h y t h is l e a d s t o a n i n f e r io r a l l o c a t i o n . F i r s t - o r d e r
c o n d i t i o n s f o r c h o o s i n g h in t h e d i r e c t o r - m e c h a n i s m a r e:
~ ( x H ) ~ , ; ( h ) = ~ r p B D ' ( h ) . ( 1 3 )
I f m a n a g e r s h a v e m o r e b a r g a i n i n g p o w e r , t h ei r c o m p e n s a t i o n d e p e n d s m o r e o n
t h e i r n e g o t i a t i n g s k i l l s t h a n o n t h e i r p e r f o r m a n c e , i . e . t h e i r i n v e s t m e n t i n s p e c i f i c
h u m a n c a p it al . T h i s r e m o v e s t h e a d v a n t a g e o f t h e d i re c t o r - m e c h a n i s m o f m a k i n g
t h ei r c o m p e n s a t i o n c o n t i n g e n t o n t h e i r i n v e st m e n t . T h e n t h e d i r e c t o r - m e c h a n i s m i s
s i m i l a r t o p u r e m a n a g e r i a l c o n t r o l i n t e r m s o f in c e n t i v e s b u t t o t al t r a n s f e rs a r e
l a r g e r s i n c e m a n a g e r s r e c e i v e l a r g e r r e n t s . I t i s t h i s d o u b l e h a z a r d w h i c h d i r e c t o r s
w i t h l o w b a r g a i n i n g - p o w e r i n t r o d u c e : t h e y a w a r d e x c e s s i v e s a l a r i e s t o m a n a g e r s ,
c a u s i n g a d i r e c t l o s s t o s e c u r i t y - h o l d e r s , a n d t h e y w e a k e n t h e l i n k b e t w e e n p a y
a n d p e r f o r m a n c e , t h e r e b y c a u s i n g a n i n d i re c t l o s s i n t h e f o r m o f p r o d u c t i v e
i n e f f i c i e n c i e s . T h e t w o t a k e n t o g e t h e r l e a d t o t h e u n i f o r m v e r d i c t e x p r e s s e d i n
P r o p o s i t i o n 5 ( i i ) .
4 .3 . C o n t r o l a n d c a p i t a l s t r u c t u r e : D e b t a n d c r e d i t o r c o n t r o l
T h e p r e v i o u s s e c t i o n h a s s h o w n t h a t i n d e p e n d e n t d i r e c t o r s h a v e t h e p o t e n t i a l t o
i m p l e m e n t t h e f ir s t b e s t i f t h e i r n e g o t i a t i n g p o s i t i o n i s v e r y s t r o n g , o t h e r w i s e a n
i n d e p e n d e n t s u p e r v i s o r y b o a r d m a y b e a m i x e d b l e s s i n g . U n d e r s u c h c i r c u m -
s t a n c es , m a n a g e r i a l d i s c r e t i o n m a y b e c h e c k e d b y c r e d i t o r s o r r a i d er s . T h e
c i r c u m s t a n c e s u n d e r w h i c h t h e y g a i n c o n t r o l o f t h e f ir m a r e d e t e r m i n e d b y t h e
c a p i t a l s t r u c t u r e a n d t h e c o r p o r a t e c h a r t e r . T h e s e m e c h a n i s m s a r e d i s c u s s e d i n t h i s
s e c t i o n i n o r d e r t o i n v e s t i g a t e a l t e r t m t i v e s t o t h e i n t e r n a l c o n t r o l s t r u c t u r e s
a n a l y z e d a b o v e . T h e f i r s t s u b s e c t i o n s h o w s h o w l e v e r a g e c a n c o n s t r a i n m a n a g e r i a l
d i s c r e t io n , w h e r e a s t h e s e c o n d s u b s e c t i o n f o c u s e s o n th e m a r k e t f o r c o r p o r a t e
c o n t r o l a s a n e x t e r n a l d i s c i p l i n i n g d e v i c e .
A s s u m e n o w t h a t o w n e r s h i p r i g h t s c a n b e t r a n s f e r r e d t o s e c u r i t y - h o l d e r s b y
u s i n g p r o f i t - c o n t i n g e n t d e b t . i . e . a f i n a n c i a l c o n t r a c t w h i c h s p e c i f i e s t h a t c o n t r o l o f
t h e f i r m i s t r a n s f e r r e d t o c r e d i t o r s i f p r o f i t s f a l l b e l o w a c e r t a i n v a l u e ( s e e b e l o w ) .
i f c r e d i t o r s h a v e t h e r i g h t t o l i q u i d a t e , t h e y w i l l a l w a y s l i q u i d a t e a t t = 1 i f
L , - x , .
> 0 , i . e . t h e y w i l l o n l y c o n s i d e r p e c u n i a r y r e t u r n s . S u p p o s e t h e f a c e v a l u e
o f d e b t F s a t is f ie s x B < F < x a 4 . T h e n i n s ta t e B , t h e f i r m i s b a n k r u p t a n d
c r e d i t o r s g a i n c o n t r o l o v e r t h e a s se t s , w h e r e a s i n s t at e M t h e f i r m is s ti ll s o l v e n t .
17 See e .g. B erkovitch et al. (1 994 ) whe re the f irs t best is implem ented only if the man ager
(entrepreneur) has
all
the b argaining power.
. . . . . T . . . . T
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E. Maug / Journal of Corporate Finance 3 (1997) 113-139 129
W h a t h a p p e n s i n c a s e o f c r e d i t o r c o n t r o l d e p e n d s c r i t i c a ll y o n th e i n f o r m a t i o n
c r e d i t o r s h a v e i n c a s e o f b a n k r u p t c y . S u p p o s e t h a t t h e d e b t i s o w n e d b y a b a n k .
S u p p o s e t h e b a n k e x p e c t s t o g a i n c o n t r o l o f t h e a ss e t s i f a n d o n l y i f s = B . T h e n
t h e e q u i l i b r i u m l e v e l o f s o l v e s
C ' ( ~ ) = p ~ ( L B - x 8 - D ( h ) ) . ( 1 4 )
N o t e t h a t t h i s i s a n a l o g o u s t o E q . ( 9 ) a b o v e . E v i d e n t l y , b o r r o w i n g f r o m a b a n k
w i l l b e c o s t l y i n t h i s m o d e l , s i n c e t h e b a n k w i l l n e e d t o r e c o v e r t h e i n f o r m a t i o n
c o s t s i n o r d e r t o b r e a k e v e n . T h e f o l l o w i n g p r o p o s i t i o n p r e s e n t s t h e m a i n r e s u l t o n
c r e d i t o r c o n t r o l ; h o d e n o t e s t h e l e v e l o f h c h o s e n b y t h e m a n a g e r i f o w n e r s h a v e
c h o s e n t h e o p t i m a l d e b t l e v e l .
P r o p o s i t io n 6 ( D e b t ) . ( i ) T w o d e b t - p o li c ie s c a n b e e x a n t e o p t i m a l f o r o w n -
ers."
1. l = {B }: t he . f i r m w i l l b e c l o s e d i n s t a t e s = B ;
2 . 1 = {M , B}: t he f i r m w i l l b e c l o s e d i n s t a t e s s = M an d s = B .
( i i ) I f t he c os t s o f ac q u i r i ng i n f o r m a t i on C ( ~ ' ) a r e s u f f i c i e n t l y l ow , t he n th i s
s o l u t i o n g i v e s i n i ti a l o w n e r s h i g h e r p r o f i t s t h a n p u r e m a n a g e r i a l c o n t r o l a n d i s
d o m i n a t e d b y t h e d i r e c t o r - m e c h a n i s m a s c h a r a c t e r i z e d i n P r o p o s i t i o n 3 ; t h e
s o l u t io n i n v o l v e s u n d e r i n v e s t m e n t i n p r o j e c t - s p e c i f i c h u m a n c a p i ta l : h D < h * .
( i i i ) I f t h e c o s t o f i n f o r m a t i o n a c q u i s i t i o n a r e s u f fi c i e n tl y h ig h , t h e n d e b t i s
d o m i n a t e d b y p u r e m a n a g e r i a l c o nt ro l .
( i v ) If" t he p r ob ab i l i ~ o f r e s t r uc t u r i n g i n t he l ow s t a te P B is s u f f i c i e n t l y l ow ,
t h e n d e b t d o m i n a t e s t h e d i r e c t o r - m e c h a n i s m .
E v e n t h o u g h o w n e r s c a n r e d u c e t h e r e n t m a n a g e r s c a n e x t r a c t r e l a t i v e t o p u r e
m a n a g e r i a l c o n t r o l , i n v e s t m e n t i n s p e c i f i c h u m a n c a p i t a l r e m a i n s i n e f f i c i e n t ,
R e c a l l f r o m P r o p o s i t i o n 2 t h a t u n d e r m a n a g e r i a l c o n t r o l m a n a g e r s o b t a i n a s t r i c t l y
p o s i t i v e r e n t ( g i v e n b y E q . ( 6 ) ) . H e n c e , w h e n e v e r o w n e r s d e t e r m i n e t h e o p t i m a l
d e b t - p o l i c y , t h e y h a v e t o o b s e r v e t w o c o n s t r a i n t s : f i r s t , m a n a g e r s ' i n c e n t i v e
c o m p a t i b i l i t y c o n s t r a i n t w h i c h r e q u i r e s :
tX( Xn ) P 'n( hD ) = P ( I ) D ' ( hD ) ( 1 5 )
a n d s e c o n d , t h e i r p a r t i c i p a t i o n c o n s t r a i n t w h i c h a m o u n t s t o t he i r r e n t r b e i n g
n o n - n e g a t i v e . F r o m A s s u m p t i o n 2 ( i i ) , i t c a n n e v e r b e p r o f i t a b l e t o l i q u i d a t e i n
s t a te s = M i f t h is r e q u i r e s a n a d d i t i o n a l p a y m e n t D ( h D ) t o t h e m a n a g e r i n t h a t
s t at e . H o w e v e r , s u p p o s e m a n a g e r s r e c e i v e a s t r i ct l y p o s i t i v e r e n t i f 1 = { B } . T h e n
l i q u i d a t i n g i n s ta t e s = M a s w e l l g i v e s o w n e r s p M ( L M - - x M ) m i n u s t h e e f f i -
c i e n c y l o s s f r o m a h i g h e r p r o b a b i l i t y o f p r o j e c t c l o s u re . T h i s e f f i c i e n c y l o s s i s
P ' n ( h ) ( x H - x M ) A h t o a f i r s t - o r d e r a p p r o x i m a t i o n , w h e r e A h i s t h e r e d u c t i o n i n h
b e c a u s e m a n a g e r s e x p e c t a h ig h e r p r o b a b i li t y o f p r o j e c t cl o s u re . N o a s s u m p t i o n o n
t h e p a r a m e t e r s o f th e m o d e l p r e v e n t s t h e n e t g a i n f r o m b e i n g p o s i t i v e , a n d
1 = { M , B } i s a n o p t i m a l p o l i c y i f t h e n e t g a i n is p o s i t i v e a n d m a n a g e r s ' p a r t i c ip a -
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E. Maug Journal of Corporate Finance 3 (1997) 113-139 131
o w n e r s , t h e y w i ll c h o o s e a h i g h e r y i f t h e y c h o o s e a h i g h e r le v e r a g e F , h e n c e
d i r e c t o r ' s s h a r e h o l d i n g s a n d l e v e r a g e s h o u l d b e p o s i t i v e l y c o r r e l a te d . I t s h o u l d b e
o b s e r v e d t h a t i m p l e m e n t i n g t h i s s o l u t i o n w i t h d e b t i s n o t t h e o n l y p o s s i b i l i t y .
D i r e c t o r s c o u l d e q u a l l y w e l l r e c e i v e o p t i o n s o r w a r r a n t s w i t h s u f f i c i e n t l y h i g h
e x e r c i s e p r i c e s t o g e n e r a t e t h e s a m e r e s u l t .
A n o t h e r l i te r a t u re o n d e b t h a s e m p h a s i z e d t h e a b i li t y o f l e n d e r s t o r e n e g o t i a t e
f i x e d c l a i m s , t h e r e b y i n c r e a s i n g t h e f l e x i b i li t y o f d e b t c o n t r a c t s . ~s H o w e v e r , d e b t
r e n e g o t i a t i o n i m p r o v e s e f f i c i e n c y m o s t l y t h r o u g h a v o i d i n g e x p o s t i n e f f i c i e n t
l i q u i d a t i o n , w h e r e a s t h e m o d e l h e r e i m p l i e s l i q u i d a t i o n s w h i c h a r e e x a n t e , b u t n o t
e x p o s t i n e f f i c i e n t . A l s o , d e b t r e n e g o t i a t i o n t y p i c a l l y s e r v e s t o a d j u s t f i n a n c i a l
c l a i m s a g a i n s t t h e c o m p a n y t o a l l o w c o n t i n u a t i o n a s a g o i n g c o n c e r n , a n d n o t t h e
a d j u s t m e n t o f e x e c u ti v e c o m p e n s a t i o n t h r o u g h c r e d i to r s .
4.4. TakeoL~ers and the role of the corporate charter
A s s u m e t h e f i r m i s f u l l y e q u i t y f i n a n c e d a n d a t le a s t a c e r t a i n p a r t o f th e
o u t s t a n d i n g s h a r e s h a v e v o t i n g r ig h t s . T h e n u m b e r o f o u t s t a n d i n g s h a r e s is
n o r m a l i z e d t o 1 . S u p p o s e a f t e r s t a g e 3 a p o t e n t i a l r a i d e r c a n t a k e o v e r t h e
c o m p a n y a n d b i d f o r t h e v o t i n g r ig h ts . M o r e o v e r , a s s u m e t h e r a id e r c a n a c q u i re a
f r a c t i o n ~b o f t h e f ir m a t th e c u r r e n t m a r k e t p r i c e P , w h e r e P i s t h e e x d i v i d e n d
v a l u e o f t h e s h a r e s a t s t a g e 3 b e f o r e a b i d i s a n n o u n c e d . E v i d e n t l y , b i d d e r s a r e
o n l y i n t e r e s t e d i n p e c u n i a r y p a y o f f s , l e a v i n g m a n a g e r s v u l n e r a b l e t o i n t e r v e n t i o n s
b y o u t s i d e rs w h o d o n o t ta k e i n t o a c c o u n t t h e l o s s th e y m a y s u f f er i f t h e ir h u m a n
c a p i t a l is d e p r e c i a te d . C o n s i d e r t h e r e f o r e t h e i n c l u s i o n o f t a k e o v e r d e f e n s e s i n t h e
c o r p o r a t e c h a r t e r w h i c h o w n e r s d e c i d e a t t h e fi r s t s t e p o f th e g a m e . H e n c e , s t a g e 4
o f t h e g a m e d e s c r i b e d i n S e c t i o n 2 h a s t h e f o l l o w i n g e x t e n s i v e f o r m :
( a ) A p o t e n ti a l ra i d e r d e c i d e s w h e t h e r t o b e c o m e i n f o r m e d a b o u t t h e f i rm a n d
t a k e i t o v e r o r n o t . I f n o t , m a n a g e r s d e c i d e a b o u t t h e u s e o f t h e a s s et s .
( b ) I f t h e r a i d e r b e c o m e s i n f o r m e d a n d d e c i d e s t o t a k e o v e r h e p u r c h a s e s ~b
s h a r e s o n th e s t o c k m a r k e t a t t h e c u r r e n t m a r k e t p r i c e P a n d a n n o u n c e s t h e
c o n d i t i o n s o f t h e b i d .
( c ) M a n a g e r s d e c i d e w h e t h e r t h e y u se t a k e o v e r d e f e n s e s i f s u c h d e fe n s e s a re
a v a i l a b l e t o t h e m .
( d ) I f m a n a g e r s d e f e n d t h e b i d s u c c e s s f u l l y , t h e y s t a y i n c o n t r o l a n d d e c i d e a b o u t
t h e u s e o f th e a s s e ts . I f t h e y d o n o t d e f e n d t h e b i d , s h a r e h o l d e r s d e c i d e
w h e t h e r t o t e n d e r t h e i r s h a r e s ,
( e ) I f t h e b i d s u c c e e d s , t h e ra i d e r g a in s c o n t r o l a n d d e c i d e s h o w t o u s e t h e a s se t s.
O t h e r w i s e m a n a g e r s s t a y i n c o n t r o l a n d m a k e d e c i s i o n s .
O n l y s t a t e s w h e r e L ~ > x~ a r e c a n d i d a t e s f o r t a k e o v e r s . T h e r a i d e r w i l l c l o s e
t h e f i r m , r e d e p l o y t h e a s s e t s a n d o b t a i n L ~ . H e n c e , t h e p o s t a n n o u n c e m e n t v a l u e
is Cf. Bolton and Scharfstein (1996) and Rajan (1992).
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1 3 2 E . M a u g / J o u r n a l q [ ' C o r p o ra t e F i n a n c e 3 ( 1 9 9 7) 1 1 3 - 1 3 9
o f t h e s h a r e i s L ~. S h a r e h o l d e r s w i l l te n d e r t h e i r s h a r e s o n l y i f t h e r a i d e r o f fe r s
L ~ , o t h e r w i s e t h e y w o u l d p r e f e r t o s t a y a s m i n o r i t y s h a r e h o l d e r s i n t h e f i r m a n d
t h e b i d w o u l d f a i l . ~9 D e n o t e b y q t h e p r o b a b i l i t y t h a t a t a k e o v e r b i d i s m a d e i f
t h e r a i d e r i s i n f o r m e d . T h i s i s a l s o t h e m a r k e t ' s e x p e c t a t i o n o f a b i d i n e q u i l i b -
r iu m . T h e n , b e f o r e t h e a n n o u n c e m e n t o f th e b i d th e v a l u e o f t h e c o m p a n y a n d t h e
m a r k e t p r i c e o f th e s h a r e i s P =
q ' r L , +
(1 -
q~' )x~ .
T h e r a i d e r ' s p r o f i t s a r e
R = 4 ) ( L s - P ) = 05 (1 -
q r ) ( L , - x , ) .
( 1 6 )
H e n c e , t h e r a i d e r w i l l t a k e o v e r w h e n e v e r R >_ 0 w h i c h r e q u i r e s
L,.
> x ~ . N o t e
t h a t R > 0 i m p l i e s t h a t th e r a i d e r a l w a y s b i d s a n d q = 1. T h e r a i d e r o b t a i n s t h e
p r o f i t R w i t h p r o b a b i l i t y r . T h i s g i v e s t h e f i rs t r e s u l t o n h o s t i l e o r u n d e f e n d e d
t a k e o v e r s :
P r o p o s i t i o n 8 ( H o s t i l e t a k e o v e r s ): I f t a k e o v e r s a r e u n d e f e n d e d , a b i d w i l l
a l w a y s b e m a d e w h e n e v e r t h e r a i d e r h a s b e c o m e i n f o r m e d a n d s = M o r s = B .
T h e r a i d e r b e c o m e s i n f o r m e d w i th p r o b a b i l i ty ~-R < 1 / 2 w h i c h s o l v e s :
M a x ~ & T e ( 1 - - T n ) ( p s ( L s - - x B ) + p M ( L M - - X M ) ) - - C ( T e ) .
( 1 7 )
M a n a g e r s r e c e i v e o n l y a p a y m e n t ~[" t h e s t a t e i s h i g h ( x H - x M > t z ( x n ) > 0 ) .
O n e i m p l i c a t i o n o f t h i s r e s u l t is t h a t th e r e m a y b e t o o f e w t a k e o v e r s a n d t h e
r e s t r u c t u r i n g p o t e n t i a l
L ~ - x B
m a y n o t b e r e a l i z e d i f t h e s t a k e t h e r a i d e r c a n
a c q u i r e i n t h e m a r k e t i s t o o s m a l l . F i r s t - o r d e r c o n d i t i o n s a r e:
05(1
- - 2 T n ) ( p B ( L n - - x s ) + p M ( L M - - X M ) ) = C ' ( T R )
( 1 8 )
a n d i m p l y t h a t r e < 1 / 2 . I f 05 i s s m a l l , r R i s g o i n g t o b e s m a l l a n d t h e i n c i d e n c e
o f t a k e o v e r s i s lo w .
I f th e r a i d e r i s s u f f i c i e n t ly i n f o r m e d , t a k e o v e r s l e a d t o e x c e s s i v e a s s e t r e a l l o c a -
t i o n b e c a u s e t h i s i s o p t i m a l a f t e r s t a g e 3 w h e n t h e d e c i s i o n a b o u t h u m a n c a p i t a l i s
s u n k a n d m a n a g e r s c a n n o t b r i b e p o t e n t i a l r a i d e r s . T h i s s i t u a t i o n p r o v i d e s a
r a t i o n a l e f o r t a k e o v e r d e f e n s e s w h i c h g i v e m a n a g e r s s o m e c o n t r o l o v e r t h e
t a k e o v e r p r o c e s s . T h e r e a r e n u m e r o u s s t r a t e g i e s t o d e f e n d b i d s . 20 S i n c e t a k e o v e r
d e f e n s e s a r e n o t t h e f o c u s o f th i s d i s c u s s i o n , n o a n a l y s i s o f t h e m e c h a n i c s o f
d i f f e r e n t d e v i c e s i s u n d e r t a k e n h e r e . A s s u m e f o r t h e r e m a i n d e r o f th i s s e c t io n t h a t
m a n a g e r s h a v e a c c e s s t o s o m e e f f e c t i v e d e f e n s e ( e . g . a p o i s o n p i l l ) , a n d t h a t a
r a i d e r c an o n l y a c q u i r e c o n t r o l o f th e a s s e t s b y o b t a i n i n g m a n a g e r s ' c o n s e n t f o r
t h e t ra n s a c t i o n . A l s o , s u p p o s e t h e c o r p o r a t e c h a r t e r c o u l d i n c l u d e a c l a u s e
s p e c i f y i n g th a t a n y s e v e r a n c e p a y r e c e i v e d b y t h e m a n a g e r i n th e e v e n t o f a
t a k e o v e r is p a i d o u t o f t h e c o m p a n y ' s c a s h f l o w s a n d t h a t th e r e is s u f f ic i e n t
19 T h i s i s f a m i l i a r fr o m t h e a n a l y s i s o f t h e f re e r i d e r p r o b l e m , c f . G r o s s m a n a n d H a r t ( 1 9 8 0 ) .
~0 S e e W e s t o n e t a l. ( 1 9 9 0 , c h . 2 0 ) f o r a t e x t b o o k t r e a t m e n t o f t a k e o v e r d e f e n s e s , a n d H e r z e l a n d
S h e p r o ( 1 9 9 0 , c h . 1 . 8) , f o r a d i s c u s s i o n f r o m a l e g a l p o i n t o f v i e w .
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133
c o m p e t i t i o n i n th e m a r k e t f o r c o r p o r a t e c o n t r o l . T h i s c o u l d b e a c h i e v e d w i t h
e x c l u s i o n d e v i c e s l i k e r e s t ri c t e d o f f e r s o f th e k i n d d i s c u s s e d i n G r o s s m a n a n d H a r t
( 1 9 8 0 ) . A l t e r n a t i v e l y , t h e b i d d e r c o u l d o f f e r t h e t a r g e t s h a r e h o l d e r s h a r e s i n th e
m e r g e d f i r m i n s t e a d o f c a s h ( a 1 0 0 % p a p e r o f f e r) . T h i s w o u l d a l s o p a s s o n t h e
b i d d i n g c o s t s t o t h e t a r g e t s h a r e h o l d e r s .
P r o p o s i t i o n 9 . A s s u m e a s u c c e s s f u l b i d d e r i s p