1. Governance and Market Efficiency René M. Stulz The Ohio State University, ECGI, and NBER

3. Stock-price focused governance Key principles: Key principles: –Management should maximize firm’s stock price –Compensate management according to wealth created as measured by change in firm’s stock price –Management should be given incentives to maximize firm’s stock price Problem: Relies critically on market efficiency Problem: Relies critically on market efficiency Why? Otherwise, management can make the right decision but the stock price can fall Why? Otherwise, management can make the right decision but the stock price can fall

4. Agenda Forms of market efficiency Forms of market efficiency Market efficiency and stock-price reactions to corporate decisions: Using acquisitions as an example Market efficiency and stock-price reactions to corporate decisions: Using acquisitions as an example Managerial incentives when markets are not strong-form efficient Managerial incentives when markets are not strong-form efficient What should be done? What should be done?

5. 1. Forms of efficiency Strong form Strong form –All information is in stock price –Does not exist when information asymmetries are important Semi-strong form Semi-strong form –All public information is in stock price –Focus of behavioral finance critique Weak form Weak form

6. 2. Stock price reactions

7. Some results 4,136 acquisitions from 1998 to 2001 4,136 acquisitions from 1998 to 2001 Typical acquisition is associated with stock-price gain but… Typical acquisition is associated with stock-price gain but… 87 acquisitions from 1998 to 2001 have dollar loss exceeding $1 billion each 87 acquisitions from 1998 to 2001 have dollar loss exceeding $1 billion each The 87 represent 43.4% of amount spent on acquisitions The 87 represent 43.4% of amount spent on acquisitions Total loss of $397 billion Total loss of $397 billion Abnormal return of -10.6%. Abnormal return of -10.6%. From 1998 to 2001: Total loss from acquisitions is $240 billion From 1998 to 2001: Total loss from acquisitions is $240 billion Abnormal return of the 87 is -10.6%. What does it mean? Abnormal return of the 87 is -10.6%. What does it mean?

8. What does the stock-price reactions mean? Depends on form of market efficiency Depends on form of market efficiency Strong-form: NPV of acquisition; shareholders are necessarily worse off Strong-form: NPV of acquisition; shareholders are necessarily worse off Semi-strong form: not NPV; long-term shareholders may be better off Semi-strong form: not NPV; long-term shareholders may be better off Weak-form: not NPV; long-term shareholders may be better off Weak-form: not NPV; long-term shareholders may be better off

9. Bottom line Actions that are associated with negative stock-price reactions may be good for long-term shareholders Actions that are associated with negative stock-price reactions may be good for long-term shareholders But, they are necessarily bad for short- term shareholders But, they are necessarily bad for short- term shareholders With strong-form market efficiency, there is no distinction between short- and long- term shareholders With strong-form market efficiency, there is no distinction between short- and long- term shareholders

10. Managerial incentives and efficiency Strong-form efficiency: maximizing stock price is the right objective. Strong-form efficiency: maximizing stock price is the right objective. Not strong-form efficiency: Not strong-form efficiency: –Management may not do the right thing from the perspective of long-term shareholders –Management may manipulate stock price through accounting

11. Fastow, March 8, 2006 "At Enron, the culture was, the business practice seemed to consistently be, to do transactions that maximized the financial reporting as opposed to maximized the true economic value," he said. "At Enron, the culture was, the business practice seemed to consistently be, to do transactions that maximized the financial reporting as opposed to maximized the true economic value," he said.

12. Are departures from strong-form efficiency important? Evidence Enron, Worldcom, Parmalat Enron, Worldcom, Parmalat Insider trading evidence? Insider trading evidence? Accounting fraud and taxes Accounting fraud and taxes Long-term returns Long-term returns What about departures from semi-strong form of efficiency? What about departures from semi-strong form of efficiency? Long-term returns Long-term returns Bubble Bubble Back to the merger case Back to the merger case

13. Mergers again Moeller, Schlingemann and Stulz (2006) examine the impact of departures from strong-form market efficiency on merger announcement returns Moeller, Schlingemann and Stulz (2006) examine the impact of departures from strong-form market efficiency on merger announcement returns Evidence shows that proxies for information asymmetries are important Evidence shows that proxies for information asymmetries are important Can’t exclude a role for departures from semi-strong form Can’t exclude a role for departures from semi-strong form

14. What should be done? Governance should be robust to departures from strong- form efficiency Governance should be robust to departures from strong- form efficiency Deadweight costs of focusing on short-term shareholders Deadweight costs of focusing on short-term shareholders Social welfare case is strongest for focusing on long- term shareholders Social welfare case is strongest for focusing on long- term shareholders Make market more efficient through greater disclosure Make market more efficient through greater disclosure Make managers bear the consequences of their actions even after they have left Make managers bear the consequences of their actions even after they have left Combine accounting and stock price performance measures Combine accounting and stock price performance measures