PPT

Topic 5: Corporate Governance

Owners or InvestorsOwners or Investors Berle and Means (1932) – Large firms Berle and Means (1932) – Large firms

→ separation of ownership and control→ separation of ownership and control Most shareholders act like passive Most shareholders act like passive

investorsinvestors Principal – agent problemPrincipal – agent problem SolutionsSolutions

Incentives Incentives MonitoringMonitoring

Need a score card?Need a score card?

Stockholder

Creditor

Employee

Society

Managers

Stakeholders Monitors Controllers

Within Firm

Outside Firm

Government

Board of Dir.

Auditors

Analysts

Bankers

Credit Agency

Attorneys

SEC

IRS

Problems with ControllersProblems with Controllers ShirkingShirking Hiring friendsHiring friends Consuming excess perksConsuming excess perks Building empiresBuilding empires Avoid risks to secure jobAvoid risks to secure job Manage to the “short-run”Manage to the “short-run” Performance standards for CEO don’t Performance standards for CEO don’t

existexist

CarrotsCarrots CEO pay usually seems excessive priceCEO pay usually seems excessive price Incentives to align manager and Incentives to align manager and

stakeholder interestsstakeholder interests Base salary and bonusBase salary and bonus Stock optionsStock options Restricted stockRestricted stock Performance sharesPerformance shares Perks – Not just country club membershipPerks – Not just country club membership Do they work?Do they work?

Not really – Jensen and Murphy (1990)Not really – Jensen and Murphy (1990) Larry Ellison has $475 M worth of optionsLarry Ellison has $475 M worth of options

CarrotsCarrots The mechanics of optionsThe mechanics of options

Stock @ $50 – CEO gets 1M, 5year, Stock @ $50 – CEO gets 1M, 5year, $50 options$50 options

5 years later, shares trading @755 years later, shares trading @75 CEO buys shares for $50, sells for $75, CEO buys shares for $50, sells for $75,

and pockets $25Mand pockets $25M Say he is a bad CEO and the stock Say he is a bad CEO and the stock

went nowhere for five yearswent nowhere for five years Options expire worthless, but at worst Options expire worthless, but at worst

CEO only loses his job CEO only loses his job But even management can give options But even management can give options

valuevalue

CarrotsCarrots Why do firms use them?Why do firms use them?

Doesn’t cost any cash or value todayDoesn’t cost any cash or value today Firm has 100 M shares w/ $1 EPS and Firm has 100 M shares w/ $1 EPS and

10M executive options. Exercise options 10M executive options. Exercise options → 110 M shares w/ $0.91 EPS→ 110 M shares w/ $0.91 EPS

Only since July 2005 firms required to Only since July 2005 firms required to expense optionsexpense options

What else is wrong with What else is wrong with options?options?

May incent CEO to forego dividends May incent CEO to forego dividends = Buffett’s RE argument= Buffett’s RE argument

May incent CEO to take on “too” risky May incent CEO to take on “too” risky projectsprojects

No incentive effect if “underwater”No incentive effect if “underwater” Manipulate earnings to time grants Manipulate earnings to time grants

and exerciseand exercise ““Rising tide lifts all boats”Rising tide lifts all boats” Nothing is universally badNothing is universally bad

SticksSticks All of the players need to take some All of the players need to take some

responsibilityresponsibility Auditors and AccountantsAuditors and Accountants Board of DirectorsBoard of Directors Investment Banks and Securities Investment Banks and Securities

AnalystsAnalysts Creditors and Credit Rating AgenciesCreditors and Credit Rating Agencies ShareholdersShareholders GovernmentGovernment Other corporations (M&A)Other corporations (M&A)

Auditors and Accountants Auditors and Accountants Internal Auditors/compliance officerInternal Auditors/compliance officer External auditors – conflict w/ External auditors – conflict w/

consultingconsulting FASB establish GAAPFASB establish GAAP May be under firm pressure toMay be under firm pressure to

Manage earningsManage earnings Meet internal targetsMeet internal targets Meet external targetsMeet external targets Window dressWindow dress Smooth earningsSmooth earnings

Board of DirectorsBoard of Directors Hire, evaluate, and/or fire top Hire, evaluate, and/or fire top

managementmanagement Vote on major operating proposalsVote on major operating proposals Vote on major financial decisionsVote on major financial decisions Offer expert advice to managementOffer expert advice to management Make sure firm’s activities and financial Make sure firm’s activities and financial

health accurately reported to shareholdershealth accurately reported to shareholders Committees – Audit, compensation, Committees – Audit, compensation,

nomination, executive, finance, nomination, executive, finance, community relations, corporate community relations, corporate governance, …governance, …

Board of DirectorsBoard of Directors Have to have good relations with Have to have good relations with

mngt., but Buffett warns of being too mngt., but Buffett warns of being too closeclose

Shareholders can hold them Shareholders can hold them responsible, but firm buys D&O policyresponsible, but firm buys D&O policy

Why would anybody be a director?Why would anybody be a director? A plum for a good friendA plum for a good friend Median compensation - $56,000Median compensation - $56,000 150 hours of work and 8 meetings a year150 hours of work and 8 meetings a year Travel, stock, options,…Travel, stock, options,… 95% are retired execs, 82% are execs 95% are retired execs, 82% are execs

from another firmfrom another firm

So what makes a good So what makes a good Board of Directors?Board of Directors?

Finance has done a lot of diggingFinance has done a lot of digging IndependentIndependent

Problem: It is a small universe to be independentProblem: It is a small universe to be independent Small boardSmall board

Problem: Free-rider (moral hazard in teams)Problem: Free-rider (moral hazard in teams) Joint CEO/Chairman of BoardJoint CEO/Chairman of Board

Problem: Is CEO the one to monitor top Problem: Is CEO the one to monitor top management and set the agenda?management and set the agenda?

Have a vested interest or offer a level of Have a vested interest or offer a level of expertiseexpertise Problem: Disney outsiders own no stock and OJ Problem: Disney outsiders own no stock and OJ

Simpson on audit committee of Infinity Simpson on audit committee of Infinity BroadcastingBroadcasting

Investment Banks and Investment Banks and Securities AnalystsSecurities Analysts

IPO process and helping with new IPO process and helping with new issuesissues Going to sell to customers. ReputationGoing to sell to customers. Reputation Need to maximize value for client. Info Need to maximize value for client. Info Less than 1% of firms that want to issue Less than 1% of firms that want to issue

IPO do so. Investment banker decides. IPO do so. Investment banker decides. During tech bubble demand forced lower During tech bubble demand forced lower

standardsstandards Facilitate M&AFacilitate M&A

Investment Banks and Investment Banks and Securities AnalystsSecurities Analysts

Analysts evaluate securities and Analysts evaluate securities and make earnings forecastsmake earnings forecasts Expert on firm and industry – Reg FD Expert on firm and industry – Reg FD

undercuts a littleundercuts a little Forecast earnings - underestimate Forecast earnings - underestimate Make buy/sell recommendation - maybeMake buy/sell recommendation - maybe Set target priceSet target price Like banking side, need to be friend of Like banking side, need to be friend of

firm to maintain relationship – “Chinese” firm to maintain relationship – “Chinese” wall may not existwall may not exist

Investment Banks and Investment Banks and Securities AnalystsSecurities Analysts

Summer 2002 regs. Analysts:Summer 2002 regs. Analysts: Not supervised by investment banking Not supervised by investment banking

operationsoperations No compensation tied to banking businessNo compensation tied to banking business Can’t promise favorable rating to get dealCan’t promise favorable rating to get deal Disclose compensation sourceDisclose compensation source Disclose relationship with firm (officer or Disclose relationship with firm (officer or

board)board) Disclose firm relationship to bank Disclose firm relationship to bank

Creditors and Credit Rating Creditors and Credit Rating AgenciesAgencies

Just another investor??Just another investor?? Risky project vs. “really risky” projectRisky project vs. “really risky” project

Corporate debt creates three Corporate debt creates three monitorsmonitors Debt itself can be disciplinaryDebt itself can be disciplinary

Miss a payment Miss a payment → lender sue for control→ lender sue for control CovenantsCovenants

Institutional lenders monitor Institutional lenders monitor Banks and other institutionsBanks and other institutions

Credit agencies monitor and rate debt Credit agencies monitor and rate debt Same “consulting” problem as analystsSame “consulting” problem as analysts

ShareholdersShareholders Why don’t they watch their own Why don’t they watch their own

investments?investments? Diverse ownership by individualsDiverse ownership by individuals

Most shareholder proposals are “cranks”Most shareholder proposals are “cranks” Large shareholders doLarge shareholders do

Kerkorian at Chrysler, now GM or Ichann at Kerkorian at Chrysler, now GM or Ichann at ImcloneImclone

Buffett owns so many can do what he wantsBuffett owns so many can do what he wants Institutionals canInstitutionals can

Public pensions are activePublic pensions are active Mutual funds hold 25% of all US stockMutual funds hold 25% of all US stock

GovernmentGovernment Depression of 1930s Depression of 1930s → SEC acts of 1933, → SEC acts of 1933,

1934, 19401934, 1940 Internet bubble Internet bubble → Sarbanes-Oxley 2002→ Sarbanes-Oxley 2002

Create board to oversee public accountantsCreate board to oversee public accountants Auditor independenceAuditor independence Corporate responsibility – CEO signs offCorporate responsibility – CEO signs off Enhanced disclosure Enhanced disclosure

SEC underfundedSEC underfunded Can’t retain good help – wages 40% < other federal Can’t retain good help – wages 40% < other federal

peers = no consistencypeers = no consistency Under staffed – since ’93 work load doubled and Under staffed – since ’93 work load doubled and

staffing unchanged staffing unchanged

Other corporations (M&A)Other corporations (M&A) I’ve talked about hubris, I’ve talked about hubris,

overconfidence, nonexistent synergies, overconfidence, nonexistent synergies, overpaying….overpaying….

Some firms really are being run poorlySome firms really are being run poorly The market system does work. (Darwin The market system does work. (Darwin

was right)was right) Takeover defenses can thwart this Takeover defenses can thwart this

mechanismmechanism Poison pillPoison pill Golden parachuteGolden parachute Staggered boardStaggered board

Where does Buffett stand?Where does Buffett stand? Attitude is partnershipAttitude is partnership Most directors have significant Most directors have significant

investmentinvestment Verify intent vs. outcomeVerify intent vs. outcome

Shareholder oriented $1 premiseShareholder oriented $1 premise Honesty Honesty

don’t need Reg FDdon’t need Reg FD Give owners tools needed to evaluateGive owners tools needed to evaluate

Options may encourage wrong behavior Options may encourage wrong behavior Next time review for examNext time review for exam