Corporate GovernanceIntroduction

• More general thing than financial contracting– Shleifer and Vishny: “corporate governance deals with

the ways in which the suppliers of finance to corporations assure themselves on getting a return on their investment”

– Tirole: interests of stakeholders other than investors should also be taken into account

– Most generally (Zingales): CG is a set of mechanisms that shape relationships between all parties to a firm. Ideally, this set should provide the parties with incentives to do ex-ante efficient investments (not necessarily monetary) and ensure efficient bargaining ex-post

Pledgeable income and efficiency

• From the “traditional” (Shleifer and Vishny) perspective the goal of corporate governance is to maximize “pledgeable income” (at the lowest cost)

• “Pledgeable income”: how much (in expected terms) the manager can credibly promise to return to investors.

• The greater it is the more confident investors are in getting their money back, hence, the more willing they are to invest in positive NPV projects

Basic framework

Assume (p+Δp)XH – I > 0, but pXH – I < 0

Incentive scheme: E gets w if success, 0 if failure.

Incentive compatibility (no private benefit extraction): Δpw ≥ B

Setting w at B/Δp, we get that the maximum (gross) return the investors can get, given IC holds:

(p+Δp)(XH – (B/Δp))

Financing stage

Project costs I.Entrepreneur has A<I;borrows at least I-A

Moral hazard stage

Choice of probability of success: p+Δp(no private benefit)or p (private benefit B)

Outcome stage

Verifiable profit:X{0, XH};Pr[X=XH] = either p+Δp or p

• The basic idea of “corporate governance” can be viewed as increasing pledgeable income through the reduction of private benefits

• It should be done in the least costly way (optimal combination of the corporate governance mechanisms)

Hence, financing is feasible iff

(p+Δp)(XH – (B/Δp)) ≥ I – A

i.e. pledgeable income exceeds the investors’ outlay

Mechanisms• Executive compensation

– Rationale: aligning managers’ objectives with the shareholders’ interests need for compensation based on stock price and other measures of performance (shares, stock-options, bonuses)

– Has risen in the US since 1970, especially due to a rise in the use of stock options in 90’s high pay-performance sensitivity (in the US equity based compensation is on average 50-60% of the total compensation)

– But is it an outcome of optimal contracting? Evidence suggests that maybe not, managers can pay themselves too much because they capture the process of setting compensation

– Stock-based compensation involves costs: e.g. short termism, excessive risk (stock options), insufficient effort (stock options), earnings manipulation…

Mechanisms (cont-d)

• Board of directors– Supposed to protect shareholders and

oversee management– In reality is often captured by the

management or controlling shareholders– Hence, in theory, need for “independent”

directors– But overall empirical evidence yields very

ambiguous conclusions about the effects board composition on firm value

Mechanisms (cont-d)

• Large investors: monitoring and control– Reduce (discourage) managerial opportunism

(self-dealing)– But involve costs

• Lack of diversification• Lack of liquidity• Excessive monitoring• Pursuing own goals at the expense of other

investors

Mechanisms (cont-d)

• Takeovers– Ex-ante effect: managerial discipline– Ex-post: efficient allocation of assets

• Value increasing takeovers should succeed• Value decreasing takeovers should fail

– Failure of both goals may occur in reality

Mechanisms (cont-d)

• “Gatekeepers”– Auditors– Financial Analysts– Credit Rating Agencies

• Should warn investors if things go wrong

• In reality sometimes fail– Conflicts of interest– Lack of incentives (lack of competition)

Mechanisms (cont-d)

• Minority shareholder actions– Proxy Fights (vote for removal of current

management)– Shareholder Activism (all kinds of pressure by a

shareholder (often an institution) on management: shareholder proposals, “focus list” of poor performers, articles in media, etc.)

– Shareholder litigation• Overall, minority shareholder actions are rare

outside US and UK, empirically have rather limited effect

• Russia: Hermitage case (see Dyck, Volchkova and Zingales (2005))

Other mechanisms

• Adopting US GAAP, IFRS (IAS)

• Hiring an independent auditor

• Cross listing (listing abroad)

• Sound dividend policy

• …

We will consider Large Shareholders and Takeovers in more detail now…