1. - - - - - - - - Chapter 20 - - - - - - - -
Corporate Governance and Performance
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2. Corporate Governance Systems in the United States
Diffuse stock ownership
Limited liability public corporation
Diffuse ownership of voting equity shares
Large number of individual share owners
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3. Requires little direct monitoring of individual firms by investors
Limited liability of investors
Diversification allows investors to ignore idiosyncratic risks of individual companies
Equity ownership shares actively traded
Commercial banks and insurance companies limited in their ability to hold large equity positions in individual companies
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4. Contractual theory of the firm
Firm as network of actual and implicit contracts
Contracts specify roles of stakeholders and define their rights, obligations, and payoffs
Potential conflicts
Contracts unable to envisage many changes in conditions that develop
Participants may have personal goals
Separation of ownership and control
Operations of firm are conducted and controlled by managers without major stock ownerships
Conflicts of interest arise between owners and managers
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5. Jensen and Meckling (1976)
Agency problem — divergence of interests between owners (the principal) and management (their agent)
Fractional firm ownership by managers can lead managers to work less and to consume excessive perquisites
Additional monitoring expenditures (agency costs) are required
Auditing systems
Bonding assurances
Organization systems
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6. Divergent interests of stakeholders
Business firms must recognize wide range of expectations of diverse stakeholders
Business firms must recognize external influences — job safety, product safety, environmental impacts
Business firms must recognize wide range of stakeholders and external influences to achieve long-run value maximization
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7. Internal Control Mechanisms
Shareholders elect board of directors to represent their interests
Problems of how all stakeholders can obtain representation of their views and interests have not been resolved
Public expectations look to board of directors to balance interests of all stakeholders
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8. Campbell, Gillan, and Niden (1999)
Analyzed how shareholders used proxy mechanism in 1997 proxy season
Shareholder-proposal rules (Rule 14a-8) allow shareholders to include proposal and 500-word supporting statement in proxy materials
Sample of 287 social policy proposals and 582 corporate governance proposals at 394 companies
43.3% of all proposals were considered for vote
Corporate governance proposals — 49.2% were voted on and 35.2% were either omitted or withdrawn
Social policy proposals — 31.4% were voted on and 61.6% were either omitted or withdrawn
Rule 14a-8 remains an important avenue for shareholders
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9. Role of the Board of Directors
Views of role of monitoring board
Pro: In theory, monitoring by board of directors can deal with problems of corporate governance
Con: Boards have been ineffective
Board fails to recognize problems of firm
Board does not stand up to top officers
External control devices such as hostile takeovers have multiplied because of failure of boards
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10. Composition of the board
Role of outside directors
Outside directors — directors who neither work for the corporation nor have extensive dealings with company
Outside directors play larger role in monitoring management than inside directors
Fama (1980)
Outside directors enhance viability of board in achieving low-cost internal transfers of control
Lower probability of collusion with top management
Fama and Jensen (1983a) — outside directors have incentives to protect and develop reputation as experts in decision control
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11. Weisbach (1988)
Tested hypothesis that inside and outside directors behave differently in monitoring top management
Outsider-dominated boards more likely to remove CEO
Replacement of CEO
Statistically significant inverse relation between firm's market-adjusted share performance in a year and likelihood of subsequent change in CEO
For outsider-dominated boards, responsiveness of removal decision to stock market performance is three times larger than for other board types
Replacement decision takes place relatively quickly
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12. Borokhovich, Parrino, and Trapani (1996)
Rosenstein and Wyatt (1990) — CAR for total sample was significantly positive when company appointed outside directors
Borokhovich, Parrino, and Trapani (1996)
Positive relation between proportion of outside directors and likelihood that outsider is appointed CEO
Market views appointment of outsider to CEO position more favorably than appointment of insider
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13. Compensation of board members
Well-structured compensation systems may motivate directors
Director stock ownership better aligns director interests with stockholders
Stock ownership requirements for directors and/or payment of part or all of directors' annual retainer in stock and stock options
Finance directors' retirements with stock
Studies find directors of top-performing companies hold greater number of shares than do counterparts at poor-performing firms
Critics argue that compensation should not be motivating factor
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14. Evaluating a board of directors
Business Week (11/25/96)
Rated boards by how close they came to meeting these recommendations:
Evaluate CEO performance annually
Link CEO pay to clear performance criteria
Review and evaluate strategic and operating plans
Require significant stock ownership and compensate directors in stock
No more than three insiders
Require election each year and mandatory retirement at 70
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15. Millstein and MacAvoy (1998)
Key committees should be composed of outside directors
Limits on number of boards and ban on interlocking directorships
Disqualify (from board) anyone receiving fees from company
Some pension funds and mutual funds judge boards by stock market performance of their companies — a "blinkered view"
Millstein and MacAvoy (1998)
Better board rating (based on either board independence or performance) associated with higher spread of return on invested capital (ROIC) over cost of capital (WACC)
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16. Ownership Concentration
Equity ownership by managers must balance
Convergence or alignment of interests
Entrenchment considerations — managerial ownership and control of voting rights may allow pursuit of self-interest
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17. Ownership and performance
Stulz (1988)
Model in which at low levels of management ownership, increased equity holdings improve convergence — enhance firm value
At higher levels of insider ownership, managerial entrenchment prevents takeovers — decrease firm value
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18. Morck, Schleifer, and Vishny (MSV) (1988)
Study based on 1980 data
Performance (measured by q-ratio) related to management or insider ownership percentages
Ownership concentration increased from 0 to 5%
Performance improved
Alignment-of-interest effect
Direction of causality may be reversed — high performance firms more likely to give managers stock bonuses
High performance firms may have substantial intangible assets that require greater ownership concentrations to induce proper use of these assets
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19. Ownership concentration in range 5% to 25% Performance deteriorated
Management entrenchment dampens performance
Ownership concentration above 25%
Performance improved but slowly
Incremental entrenchment effects attenuated
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20. McConnell and Servaes (MS) (1990)
Replicate MSV study using 1976 and 1986 data
For 1976, relationship between ownership concentration and performance relatively flat with moderate convergence of interest effect up to 50%, after which curve flattens and then declines moderately
For 1986, relationship curve rises relatively sharply to 40%, after which it is relatively flat to 50% followed by sharp decline
Leverage, institutional ownership, R&D expenditures, and advertising expenditures do not change initial findings
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21. Cho (1998)
Replicates MSV patterns using ordinary least square regressions and 1991 data
Tests for endogenous ownership structure
Finds that corporate value affects ownership structure, but not reverse
Bristow (1998)
Sample of consistently derived insider holdings on 4,000 firms during
Relationship between management ownership and performance varies for each of the ten years
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22. Economic variables influence ownership-performance relationship
Relative growth rates of industries
Differences in demand-supply relationships among industries
Relative value change patterns among industries and firms within them
Stock price movements
Interpretations of diverse data patterns
May reflect economic identification problem discussed by Cho
True relationship may be Demsetz-Lehn theory of no relationship between ownership level and performance
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23. Holderness, Kroszner, and Sheehan (1999)
Percentage of managerial equity ownership
Mean increased from 12.9% in 1935 to 21.1% in 1995
Median increased from 6.5% in 1935 to 14.4% in 1995
Doubling of managerial ownership may imply improvement in corporate governance in U.S.
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24. Managerial ownership and bond returns — Bagnani, Milonas, Saunders, and Travlos (1994)
No relation between bond returns and managerial ownership below 5%
Positive relation for managerial ownership between 5% and 25%
Increased incentives for managers to act in shareholders' interest, taking risks that are potentially harmful to bondholders
Rational bondholders required higher returns
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25. Weak negative relation for ownership above 25%
Managers become more risk averse
Managers have high stake in firm — greater incentives to protect their private benefits and objectives
Managers' interest more aligned with bondholders — lower bond premia
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26. Financial policy and ownership concentration
Share repurchases financed by debt
Insider group does not tender its shares in repurchases — percentage equity shares increased
Increased convergence of interest effect
Incentive effects of high management ownership percentages performed positive role in LBOs and MBOs
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27. Safieddine and Titman (1999)
Sample of 573 firms that successfully resisted takeover attempts during
Effects on leverage
Increased leverage is one form of defensive strategy
In 207 firms, median leverage ratio increased from 60% to 71.5%
Corporate restructuring activity
Turnover of top management during three-year window
30% for low leverage increasing group
37% for higher leverage increasing firms
Turnover of top management after takeover attempts
44% replaced in hostile takeover attempts
29% replaced in friendly takeover attempts
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28. Operating performance improves and long-run post-termination performance of leverage-increasing targets superior to benchmark
Returns grow by about 55% after five years
Level of returns same as what would have been realized by accepting takeover offer
Manager's behavior of leverage-increasing target firms consistent with long-term interest of their shareholders
Strong long-term abnormal stock price performance despite initial drop at takeover termination announcement
Associated productivity improvements
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29. Amihud, Lev, and Travlos (1990)
Sample of firms that made cash acquisitions of over $10 million of other firms during
Cash acquisitions are associated with significantly larger insider ownership levels than stock financed acquisitions
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30. Executive Compensation
Conflict of interest between owners and managers reduced if executive compensation plans more tightly related pay to performance
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31. Executive compensation and changes in value of firm
Jensen and Murphy (1990)
Executive pay changes only $3 for $1,000 change in firm wealth — elasticity of 0.3%
Low elasticity indicates executive pay is not closely linked to performance
But low elasticity partially explained by large value of firm in relation to executive compensation
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32. Haubrich (1994) — derived Jensen-Murphy results using principal-agent theory models
Schleifer and Vishny (1995) — Jensen-Murphy relationship would generate large swings in executive wealth and would require considerable risk tolerance for executives
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33. Executive compensation and firm's corporate governance — Core, Holthausen, and Larcker (1999)
Sample of 495 observations for 205 publicly traded U.S. firms during
Board of director characteristics and ownership structure significantly related to CEO compensation
CEO compensation higher
CEO was also board chair
Board was larger
Greater percentage of outside directors appointed by CEO
More outside directors considered 'gray'
Outside directors older and served on more than three other boards
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34. CEO compensation lower
Greater percentage of inside directors in board
Lower CEO's ownership stake
Existence of non-CEO internal board members or external blockholders who owned at least 5% of equity
Significant negative relationship between compensation predicted by board and ownership variables and subsequent firm operating and market performance
Board and ownership variables are proxies for effectiveness of firm's governance structure
CEOs of firms with greater agency problems were able to obtain higher compensation
Firms with greater agency problems perform worse
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35. Executive compensation and performance measures
Criticism that compensation had been based on accounting measures rather than stock market-based performance measures
Rappaport (1986)
Early executive compensation performance plans were market based
In 1970s, performance measures for granting options shifted to accounting-based measures
In recent years, performance is moving to market-based measures
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36. Other proposals for improved pay-performance policies
Limit base salaries of top executives
Bonus and stock option plans based on stock appreciation
Stock appreciation benchmarks should consider
Close competitors
Wider peer group
Broader stock market indexes
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37. Stock options based on premium of 10-20% over current market and should not be repriced
Company loan programs should enable top executives to buy substantial amounts of firm's stock
Directors should be paid mainly in stock with minimum specified holding periods
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38. Outside Control Mechanisms
Stock prices and top management changes
Warner, Watts, and Wruck (1988)
Poor stock price performance likely to result in increased rate of management turnover
Evidence of several internal control mechanisms — monitoring by large blockholders, competition from other managers, discipline by board
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39. Denis and Denis (1995) Announcement of changes in management
Forced resignations: Positive 1.5% (significant)
Normal retirements: Insignificant effects
Forced top management changes
Preceded by significantly large operating performance declines and followed by significant improvements
Associated with significant downsizing measured by declines in employment, capital expenditures, total assets
Improvements did not result from effective board monitoring
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40. 13% of 853 sample were forced changes
Two-thirds of forced resignations associated with blockholder pressure, financial distress, shareholder lawsuits, and takeover attempts
56% of firms with forced changes became target of corporate control activity
Internal control mechanisms were inadequate; required pressure from external corporate control markets
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41. Role of stock market
Schleifer and Vishny (1997) survey does not develop potential role of stock market and security price movements in disciplining managers
Security price movements provide scorecard measuring management performance
Bad scores on stock market increase likelihood of managerial turnover
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42. Public pension funds
Public pension funds have ability and size to become significant factors in corporate governance
California Public Employees' Retirement System (CALPERS) publicly announced names of companies that failed to negotiate adoption of corporate reforms
World’s largest pension plan, TIAA-CREF, encourages companies to have independent, diverse boards
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43. Carleton, Nelson, and Weisbach (1998)
Described negotiation process between TIAA-CREF and target firms on governance issues
All firms agreed to institute confidential voting
Most firms contacted added women or minorities to board
Most firms that were asked to limit use of blank check preferred stock as antitakeover defense complied
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44. Wahal (1996) Nine activist pension funds in period 1987-1993
Activist proposals shifted from takeover-related proxy proposals in late 1980s to governance-related proposals in 1990s
Takeover-related proxy proposals — poison pills, greenmail, antitakeover provisions
Governance-related targeting — golden parachutes, board composition, compensation
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45. Abnormal returns
Zero average abnormal returns for shareholder proposals
Small positive abnormal returns for attempts to influence target firms in using shareholder proposals (nonproxy targeting)
No significant long-term improvement in either stock price movements or accounting measures in post-targeting period
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46. Strickland, Wiles, and Zenner (1996)
Studied United Shareholders Association (USA) from 1986 to 1993
USA developed a Target 50 list of firms
USA successfully negotiated corporate governance changes in 53 proposals before inclusion in proxy statements
Abnormal return to target firm = 0.9% at announcement of negotiated agreements — wealth increase of $1.3 billion
USA effective when target firm was poor performer with high institutional ownership
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47. Multiple Control Mechanisms (Agrawal and Knoeber, 1996)
Sample of 400 largest firms
Consider seven control mechanisms
Insider shareholdings
Outside representation on board
Debt policy
Activity in corporate control market
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48. Firm performance measured by Tobin's q Results
Institutional shareholdings
Shareholdings of large blockholders
Managerial labor market
Firm performance measured by Tobin's q
Results
Considering influence of each control mechanism separately — first four control mechanisms statistically related to firm performance
Considering all mechanisms together, but not within simultaneous equation system — influence of insider shareholdings drops out
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49. Considering all mechanisms together and using simultaneous equation system — only negative effect on firm performance from outside representation remains
Concluded that control mechanisms chosen optimally except for use of outsiders on boards (most other studies find positive benefits from use of outsiders)
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50. Proxy Contests Background
Definition: Attempts by dissident groups of shareholders to obtain representation on board of directors
Success of proxy contests
Most fail to get majority representation
Better measure of success: Whether dissident group gains at least two members on board — one to make motion, another to second it
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51. Focus of empirical studies
Proxy reform rules
Under old rules: Any shareholder who wanted to communicate with more than ten other shareholders required to submit comments for SEC approval prior to circulation
Under new rules of October 1992: Ease requirements for shareholders not seeking control to communicate with one another
Focus of empirical studies
Disciplinary value of proxy contests in managerial labor market
Relationship between proxy contests and other forms of takeover activity
Value of vote
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52. Wealth effects — Earlier studies
Dodd and Warner (1983)
96 proxy contests over period
Dissidents won majority on board in only 20% of cases
Returns to target shareholder positive and significant = 6.2% from 39 days before announcement through outcome
Hypothesis to explain positive returns
Even minority board representation allows dissident group to have positive impact on corporate policy
Challenge alone (even if no seats change hands) may lead incumbents to improve policy
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53. No evidence of stock price declines when contests fail
Possibilities of increased efficiency exposed during contests
Negative abnormal returns at contest outcome announcement for contests in which dissidents failed to win any seat at all (-1.4%), not large enough or significant to offset earlier gains
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54. Information leakage
Inevitable due to mechanics of waging proxy contest
Significant abnormal returns of 11.9% over period starting 60 days before announcement through announcement itself
Returns not attributable to merger activity — results are similar regardless of whether or not dissident group included another firm
No unexpectedly higher earnings in preannouncement period to explain runup
Conclude proxy contest is source of positive returns
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55. DeAngelo and DeAngelo (1989)
60 proxy contests during
Dissidents successful in one-third of contests
Returns to shareholders
40 days before contest through outcome announcement = 6.02% significant
40 days preceding any public indication of dissident activity = 18.76% significant
Gains not dependent on contest outcome
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56. Negative returns at outcome when dissidents won no seats
Two-day outcome announcement period = -5.45%
When incumbents prevailed in shareholder vote — insignificant negative return (-1.73%)
When dissidents defeated by other means — significant negative return (-7.19%); include:
Expenditure of corporate assets to buy off dissidents
White knight acquisition of target
Court approval of validity of incumbent's defense causing dissidents to withdraw
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57. Strong link between proxy contests and takeover activity
Follow-up on targets for three years after contest
Only 20% remained independent public firms under same management
In 20 of 39 firms in which dissidents failed to win majority, there were 38 resignations of CEO, president, or chairman of board
25% (15 cases) were sold or liquidated
Most of the gains to proxy contest activity are closely related to merger and acquisition activity
Initial precontest gains (about 20%) reflected increased likelihood of eventual sale of firm at premium after proxy contest
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58. Firms not sold/liquidated — less significant abnormal return = 2.9%
Split sample results
Firms eventually sold/liquidated — abnormal returns over full contest period = 15.16%
Firms not sold/liquidated — less significant abnormal return = 2.9%
Initial runup for both classes revised as more information becomes available about likelihood of sale
Goal of proxy contests — get representation on board to persuade rest of board to sell or liquidate
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59. Sridharan and Reinganum (1995)
79 hostile tender offers and 38 proxy contests
Proxy contest more likely to take place
Target firm performance is relatively poor as measured by return on assets and stock returns
Managerial inefficiency
When shareholdings of management are high
Tender offers more likely when
Firm fails to pursue new and profitable investment opportunities
Tender offer targets tend to be less leveraged than firms experiencing proxy fights
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60. Wealth effects — Later studies
Borstadt and Zwirlein (1992)
142 firms involved in proxy contests during
Sample divided into two groups
Full-control sample — Dissident success rate = 42%
Partial-control sample — Dissident success rate = 60%
Turnover rate of top management after proxy contest higher than average
Positive abnormal return of 11.4% (significant) during proxy contest period (60 days prior to announcement of contest through contest resolution announcement)
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61. Ikenberry and Lakonishok (IL) (1993)
97 election contests during period
Test hypothesis that proxy contest represented referendum on management's ability to operate firm and can act as disciplinary mechanism
Contest targets underperformed control firms by 39.3% (significant) over five-year period prior to announcement of election contest
Proxy contest appears to be stimulated by poor performance
Return to shareholders
For period from month -60 to month -5 relative to announcement of contest, CAR of proxy contest targets = -34.4% (significant)
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62. Incumbent board members retain all their seats: CAR not significantly different from zero for five-year period following contest
Dissidents gain at least one board seat: CAR from month +3 to +24 = -32.4% (significant)
Dissidents gain control of board: CAR from month +3 to +24 = -48% (significant); negative return due to
Overoptimistic expectations of improved performance
Dissidents' discovery that company faced more serious problems than anticipated
Negative returns different from positive returns found in earlier studies
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63. Mulherin and Poulsen (1998)
Sample of 270 proxy contests for board seats during
Returns to shareholders
Day 0 = date of contest initiation; Day R = contest resolution date
Initiation period [-20,+5]; CAR = +8.04% (significant)
Post-initiation period [+6,R]; CAR = -2.82% (not significant)
Full-contest period [-20,R]; CAR = +5.35% (significant)
Post-contest period of one year following contest resolution; CAR = -3.43% (borderline significant)
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64. Results contradict substantial decline in post-contest period reported by IL
Performance measurements sensitive to survivorship bias arising from minimum data requirements
IL's requirement that firm be listed in Compustat in period around contest led to downward bias in estimated wealth changes
Compustat requirement excluded sizeable number of firms that were acquired in period surrounding proxy contest
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65. Management turnover and shareholder returns
Management turnover should be integral part of interpretations of changes in shareholders wealth in post-contest period
IL reported wealth decline, whether dissidents attained seats or not, but failed to observe that wealth changes following proxy contests were positive when there was management turnover
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66. The M&A Market for Control
Market for corporate control most widely recognized form of external pressure
Empirical metrics demonstrate M&As do impact business firms
Mitchell and Mulherin (1996)
1,064 firms listed in Value Line Investment Survey at end of 1981
57% of these firms had been either a takeover target or had engaged in defensive asset restructuring
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67. Schwert (1996) Mergerstat Review
Comment's M&A proprietary database of all NYSE- and AMEX-listed target firms from
1,814 target firms, a substantial percentage of total listed firms
MBOs represented 11.4% of main sample of 1,523 firms
Mergerstat Review
Many M&A announcements in recent years
3,510 in 1995
9,278 in 1999
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68. M&A market is major source of external control mechanisms — indicates at least some degree of failure of internal control mechanisms
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69. Alternative Governance Systems
Summary of U.S. governance system
Managerial stock ownership has increased over time
Large and small shareholders protected by well-developed systems of laws, court decisions, and financial market that facilitate
Efficient transaction of securities
Protect minority rights
Enable shareholders to sue directors for violations of fiduciary duty
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70. Changes in stock market prices quickly penalize companies for poor performance and reward them for excellence
Vigilant stock market may cause managers to emphasize short-term results
Bankruptcy laws are highly protective of managers; after entering into bankruptcy
Management remains in possession of company
Provision is made for automatic stay
Interest continues to accrue only on fully secured debt
New financing is facilitated since it has priority status
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71. Shleifer and Vishny (1997) German governance system
Creditors have stronger rights than in U.S.
Shareholder rights are weaker than in U.S.
Large shareholders, often major banks and financial groups, exercise control over large firms as permanent investors and lenders
Small investors have virtually no participation in stock market
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72. Japanese governance system
Degree of protection to shareholder and creditor rights fall between U.S. and Germany
Powerful banks and long-term shareholders in Japan not as powerful as in Germany; anecdotal evidence questions this conclusion
Japanese companies have financed in U.S. during earlier periods of time when Japan supposedly had lower financing costs than rest of world
Japanese firms sought to avoid strong controls that came with financing from Japanese banks
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73. Industrial firms own shares in one another and groups of firms become tied together by cross-shareholdings (Kaplan, 1994)
Governance system has facilitated participation by small investors in stock market
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74. U.S., Germany, and Japan have in common well-articulated set of rules that provide effective legal protection for at "least some type of investors" and are enforced by courts and regulatory agencies
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75. Governance systems in other countries
Italy
Predominantly family controlled
Difficulty raising outside funds
Investment mainly financed internally
Bank financing mainly by state banks for state firms
Rest of world
Similar to Italy
Absence of system of laws, regulations, and courts to protect minority investors and creditors
Rules of game are deficient
Large firms, mostly family controlled, rely on internal financing, or obtain help from government controlled banks
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76. Economist (1994)
German and Japanese corporate governance differ from U.S.
Stronger role of banks and financial groups
In theory, large ownership position of owners-lenders lead to effective monitoring
Critique of German and Japanese corporate governance model
Banks have not monitored closely firms to which they provide both equity and debt capital; banks become active only when client firms experience difficulties
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77. Large banking corporations have their own governance problems
German and Japanese models appear good only because of earlier favorable economic environment — all parties have same long-term interests and goals
As economic growth slows, conflicts of interest among different stakeholders arise
Supervisory boards (in Germany particularly) did not seem to meet often enough and acted slowly
Incompetent managers permitted to complete standard 5-year contract
Chairman of board often leader of executive board
Supervisory boards not adequately informed
Large banking corporations have their own governance problems
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78. Conclusion: American-British systems of shareholder control works better
Market-based
Increased activism of pension funds
Active market for corporate control in form of M&A activity
Increased M&A activity in Japan and Germany after 1999
Consistent with deficiencies of internal control mechanisms
Outside market for corporate control was needed to improve corporate performance
©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 78