. 35
( 39)


• The entrepreneur™s situation becomes outright dire if the project duration exceeds his
lifetime, and he must hand it over to professional managers. In this case, he will only earn
$35 million”the $30 million in theft will go to future management. (The entrepreneur
may somehow be able to award the management to the team that agrees to share the $30
million with him”but this will lead to a whole new set of agency con¬‚icts.)

In sum, our entrepreneur is best o¬ if he can just prevent all future managerial theft (his own
and future managers™) by instituting good corporate governance. Our entrepreneur is worse o¬
if he cannot prevent future theft by himself. Our entrepreneur is even worse o¬ if he cannot
prevent future theft by other managers. And our entrepreneur is worst o¬ if he does not
take the project. It is also not di¬cult to construct examples in which future theft completely
prevents any ability to raise funds for otherwise productive projects. The main insight from
this example is that owner-entrepreneurs have an incentive to control agency problems in order
to be able to raise capital at good terms.
¬le=governance.tex: RP
Section 28·2. Managerial Temptations.

How Strong are the Entrepreneur™s Control Incentives?
We know that the original owner-entrepreneur”unlike subsequently hired executives”can cap- The control of agency
problems is often
ture the gains from agency controls. An important question is to what extent an entrepreneur
neither easy nor
would write contracts upfront (ex-ante) that control all these agency issues. There are at least worthwhile for the
two limiting factors: original entrepreneurs.

1. It is impossible to write contracts for all future contingencies, especially insofar as man-
agerial schemes are concerned. The human mind can be very creative: What a piece of
work is man! how noble in reason! how in¬nite in faculty. Worse, many agency control
clauses could even be counterproductive if they rob executives of ¬‚exibility that could be
used to increase ¬rm value.

2. The entrepreneur™s incentives to write the appropriate contracts may be surprisingly mod-
est. Few companies are designed for greatness in the far future. When Thomas A. Edison
designed the corporate charter of General Electric in 1880, he probably did not do so with
an eye towards General Electric managers in the 21st century. Indeed, most companies
that go public will never face large agency problems”most will simply end up bankrupt.
Only 1 out of 100 may become large enough to indulge signi¬cant agency con¬‚ict”say,
costing 1% of ¬rm value. One percent of a $100 billion company is $1 billion (say, $100
million a year as a 10% perpetuity), but in ex-ante terms, it is a cost of 1/100 · 1% ≈ 0.01%
of the entrepreneur™s value.
Moreover, it is unlikely that the entrepreneur could even capture this much. The question
is to what extent investors would understand better corporate governance controls and
be willing to pay for them. How many investors would have paid Edison more money for
GE in the year 1900 if GE had put better incentives into place for the year 2000? In the
next section, we will discuss some mechanisms, such as takeovers, by which shareholders
can rein in poor management in already publicly traded companies. Su¬ce it to say here
that these mechanisms are expensive and therefore no panacea, either.

This leads us to a mixed conclusion: The entrepreneur™s incentive to control immediate man-
agerial agency con¬‚icts is probably fairly strong. However, the entrepreneur™s incentive to set
up an e¬ective charter for the long run”if even possible”is modest. Thus, it is not surprising
that we see many older Fortune 500 companies in which the entrepreneurs™ design no longer
plays much of a role in shareholders™ control over management. Thus, we need to look towards
other mechanisms that can substitute for the failing role of upfront corporate design as the
corporation ages.
Solve Now!
Q 28.1 What are the main control rights of debt and equity

Q 28.2 Describe the main illegal and legal temptations that managers face in their duty to max-
imize shareholder wealth.

Q 28.3 When are the incentives to control agency con¬‚ict strongest? Can you give a numerical

Q 28.4 What limits are there to writing a corporate charter that eliminates future agency con-
¬le=governance.tex: LP
708 Chapter 28. Corporate Governance.

28·3. Equity Protection

After the ¬rm has gone public and shareholdings have become di¬use, what can control man-
The primary control
right of equity is its agement? We will discuss a number of possible mechanisms. We begin by reexamining the
vote, but there is also
need to raise ¬nancing after the IPO. Recall that the sale of the ¬rm was the primary mecha-
the need to raise funds
nism to motivate the entrepreneur to control con¬‚ict of interest when the ¬rm starts. We then
and some external
discuss mechanisms that are based on the most important formal control right of public equity,
which is its right to vote. Ultimately stemming from the right to vote are three further control

1. Shareholders can vote in the corporate board, which can replace the management or liq-
uidate the ¬rm.

2. Unfortunately, in a widely held company, gathering votes to control management and
corporate change is not cheap. The right to vote is therefore of much use only during
unusual situations, such as a proxy contest or a hostile takeover. We therefore look at
this “external market for corporate control” in more detail.

3. Large-block shareholders can more easily in¬‚uence management, because managers know
that poor performance can lead them to withdraw their support and throw it to a potential
buyer. However, large shareholders can also do more harm than good.

Finally, we look at two external control mechanisms:

1. The legal environment regulates what managers and board member can and must do.

2. Ethical considerations and adverse publicity can constrain the norms that govern the
behavior of managers.

28·3.A. Subsequent Equity O¬erings

We ¬rst continue with the example from the previous section. We want to ask whether the
Among publicly traded,
older, cash cow need to raise capital provides managers with the incentives to control agency con¬‚icts, just
companies, even the
as it provides the incentives for the entrepreneur to control agency con¬‚icts. The answer is
need to raise capital
often no. Unlike the owners, the managers of an already publicly traded corporation typically
need not help.
own little of the ¬rm. Therefore, their incentives to curtail agency issues are weak or even
perverse”they are the immediate bene¬ciaries of agency problems. Once they are in charge,
their desire for more power and control is likely to quickly overcome their desire to control
agency issues. This is especially pertinent in widely held, large, old, cash-rich ¬rms, in which
the executives/boards have enjoyed long tenure. In this case, the need to raise capital is not
necessarily an inducement to institute good corporate governance. In fact, quite the opposite
can happen.

• Assume that professional managers are now ¬rmly in charge of our $60 million ¬rm from
above. They now happen to ¬nd another project that costs $50 million, which produces
cash ¬‚ows of $50 million in today™s dollars for an NPV of $0, but which allows for an
additional $20 million of managerial theft, leaving owners with only $30 million. (Such
projects are easy to ¬nd.)
We know that the existing company is worth $60 million. If the new project is taken,
new shareholders will own a claim on $30 million in value from the new project and $60
million in value from the old project. To raise $50 million in capital for a $90 million
company requires issuing shares worth 55% of the company. Old shareowners will now
own only 45% of the company for 45%·$90 = $40 million in the new ¬rm, down from $60
million. In e¬ect, the $20 million agency cost is now paid to buy corporate growth at the
expense of old shareholders”growth that the managers will enjoy.
¬le=governance.tex: RP
Section 28·3. Equity Protection.

• In fact, fearing similar expropriation in the future, new shareholders may demand even
more than 55% of the company”and managers have the incentive to give it to them in
order to execute this new project.

Thus, the need to raise capital is not a guarantee that the management of a publicly traded
corporation will want to control agency problems. On the contrary, raising capital can become
yet another mechanism that helps managers extract shareholder wealth for themselves. Old
capital in e¬ect allows new capital to be raised, and thereby allows managers to expand the
¬rm for a long time. Even if managerial looting has reduced the value of $10 million of old
equity into just $1 million now, managers might still want to raise another $1 million in capital
for their personal consumption by promising 51% of the new ¬rm, leaving old shareholders
with only $490,000.

28·3.B. The Corporate Board

We now move on to the main right of public shareholders: during the annual meetings, share- The board is supposed to
represent shareholders
holders get to vote on the corporate board. It is the board™s legal responsibility to oversee
and control managers.
management and to ensure that managers are acting in the interests of shareholders. The
board is the legal principal of the corporation.
The Chairman of the Board not only directs management to produce the necessary information, The agenda and
information available
but also controls the board™s agenda. Ultimately, the chairman does have to rely on manage-
are important sources of
ment, though, in asking for the right information to present for discussion. The power to set real power.
the agenda and control the information available should not be underestimated. After all, with
only a couple of days per year on the job, and with their own full-time jobs to attend to, board
members cannot possibly know the business in great detail. Thousands of pages of readings
as preparation for the board meeting”possibly with, possibly without key information”are
often just as useful to board members as zero pages. And board members know that if they do
not stick to the speci¬c agenda, the risk is that the discussion will degenerate into long-winded,
unfocused conversations. Not surprisingly, large boards are usually less e¬ective.
In many U.S. corporations, the power of the chairman relative to that of the CEO does not even Most corporations have
no Chairman to oversee
matter because the CEO is also the chairman of the board. For example, in 2003, out of the
the CEO.
thirty Dow-Jones Index companies, only four (General Motors, Intel, Microsoft, and Wal-Mart)
had both a CEO and a chairman. This arrangement obviously makes it highly unlikely that the
chairman of the board will control and, if necessary, discipline the management.
How independent are other directors? New members of the board are usually either proposed The board is often
controlled by the CEO.
by the chairman of the board or nominated by a committee of other board members. The
There usually is no
board is then put forth as a slate for an up-or-down vote at the annual shareholder meeting. meaningful shareholder
Shareholders cannot vote for or against particular candidates. (In the extreme, a shareholder vote for directors.
with 49% of the shares could ¬nd herself with zero board representation.) Most corporate
board elections are about as democratic and thrilling as elections in North Korea. The most
common outcome is that between one-third and two-thirds of the board are also employees of
the company, and thus under the direct day-to-day control of the CEO.
Michael Weisbach studied 495 corporate boards from 1974 to 1983 and classi¬ed directors as Many ¬rms have a
majority of corporate
insiders if they were full employees of the company. This would necessarily put them under
employees on the board.
the direct control of the CEO. Only about one-half of the 495 NYSE corporate boards even (Such) boards tend not
had a majority of outside directors! Only 128 had boards with clear majorities of outside to ¬re poorly
performing managers.
directors, though many of these had their own dealings with the company and were thus also
con¬‚icted. Fortunately, the presence of inside rather than outside directors does not seem to
matter much, either. In the ten years from 1974 to 1983, the probability that a manager would
depart increased only from around 5% to 6% when a company lost 33% (!) of its stock market
value (market adjusted)”and this retirement increase may have been because the manager
was already close to retirement (and had maximized his own take). Firms with more than
60% outside directors only had an additional 1% resignation frequency; and for ¬rms that lost
“only” 10% to 25% of their values, having a majority of outside directors did not even increase
the resignation frequency at all.
¬le=governance.tex: LP
710 Chapter 28. Corporate Governance.

In sum, it is usually the case that it is not the board that controls the CEO, but the CEO who
As corporate control
mechanisms, except in controls the board. Almost any CEO, who was originally successful and who is eager to gain
extreme situations,
full control, can stack the board with dependents and friends within a couple of years. Conse-
corporate boards are
quently, in most corporations, the boards are e¬ective control mechanisms only in three cases:
¬rst, when there is a large in¬‚uential shareholder to whom some board members owe loyalty;
second, when the CEO/Chairman is fairly new and has not yet taken full control of the board (or
has not shown the appropriate interest in doing so, a rare but occasional condition); and third,
when the CEO™s misbehavior is so egregious that board members begin to fear negative public-
ity and personal legal liability. We discuss the ability of the media to embarrass managers”and
set politicians, lawmakers, and enforcement into motion”below.
When it comes to proactive control of managerial misbehavior, most corporate boards in the
Corporate boards can
serve other mechanisms. United States today are more theatrical stages than e¬ective corporate control mechanisms.
This is not to say that corporate boards do not serve other useful functions. For example,
they can advise executives, they can signal a commitment to diversity, they can help build
relationships with suppliers and customers, and they can help to ¬nd a new CEO if the current
CEO suddenly “evaporates.” The discrepancy between the supposed role and the actual role
for many boards is so large that many reform ideas focus on improving the independence of
corporate boards. If legal reform were to reduce the cozy relationship between board and
management, management could indeed be better controlled”but it could come with cost. It
might allow large shareholders to extort more value for themselves at the expense of small
shareholders, it might reduce other bene¬cial functions of the board (better relations with
suppliers, etc.), and it could even destroy the company, if the relationship between management
and board were to degenerate into war.

28·3.C. The Role of Votes

Takeovers, Proxy Contests, and Shareholder Resolutions
The right to vote becomes relevant during a hostile takeover (formally called an unsolicited
Hostile takeovers seek to
acquire and then vote bid), in which an acquirer makes a tender o¬er to purchase shares in order to obtain either the
shares. Proxy contests
whole ¬rm or a voting majority. In a proxy contest, a large shareholder actively solicits other
just seek votes to change
shareholders to vote against management™s board and in favor of an alternative board. Often,
management and the
the two go together, in that a hostile acquirer also launches a proxy contest to eliminate the
board and charter provisions that would prevent him from purchasing all shares.

Anecdote: Executive Succession in Action
Through board control, CEOs usually can often determine their successors (and more than one successor has
found huge skeletons in the closet). Recall that on many boards, the Chairman/CEO has considerable in¬‚uence
over which board members should retire and who the next board™s members should be. Of course, these board
members in turn nominate the executive compensation committee, who in turn decide on the Chairman/CEO™s
A study of compensation committee membership found that when a director sits on the executive compensation
committees (which determine the pay of the managers) of multiple ¬rms, these tend to have similar executive
severance pay packages. After all, it is easier to argue for a higher compensation package for oneself, when
one can convey authoritatively that the CEO of a similar company required and received a higher pay package.
Conversely, would you think it easy to argue to your own board that you should be paid more if you just
managed to severely reduce the compensation of another CEO?
For example, the chair of IBM™s compensation committee is Charles Knight, whose own exit package from
Emersen Electric had a provision similar to one in Jack Welch™s package from General Electric. Not surprisingly,
IBM CEO Lou Gerstner™s separation package was similar to Jack Welch™s. (Both Knight™s package and Gerstner™s
package were among the most generous around.) Ivan Seidenberg, CEO of Verizon, was singled out by the
report for enjoying one of the most egregious severance packages. Seidenberg sits on Honeywell™s compensation
committee”and Honeywell was also singled out. Source: corporatelibrary.com.
¬le=governance.tex: RP
Section 28·3. Equity Protection.

A more modest form of the proxy contest is the shareholder proposal, which only rarely seeks How to get a shareholder
proposal up for vote.
to eliminate management outright. Shareholder proposals have been particularly successful
in removing anti-takeover defenses, including in some cases the staggering of the board (see
below). However, they are often not binding, and can therefore be ignored by the board. So they
are only useful in setting the stage for later actions against poorly performing management.
Any shareholder can put forth a shareholder proposal or proxy contest for vote by all sharehold-
ers. The SEC judges whether shareholder proxy suggestions are appropriate for shareholder
vote. (The rules by which the SEC accepts or rejects shareholder proposals are explained in
www.sec.gov/interps/legal/cfslb14.htm.) In addition, many shareholder proposals are brought
by special interest groups, such as churches or labor unions, and are not necessarily in the
interest of shareholders, either.
Obviously, engineering a hostile takeover is neither cheap nor easy. But even proxy contests Gains must be very large
to make voting action
and shareholder resolutions are costly and only occasionally successful mechanisms. Clearly,
worthwhile. Proxy
to wage either, the value gains from dislodging management must be large enough. “Modest” contests are costly and
governance problems, such as an executive salary of $100 million in a $10 billion company (1% (only) modestly
of value), are just not enough to make the expense worthwhile. Therefore, proxy contests are
rare. For example, Institutional Shareholder Services (issproxy.com) reports that there were 17
proxy contests in the ¬rst 8 months of 2003, of which only 4 resulted in dissident victories.
The average dissident™s cost per proxy contest was about $1 million. (The highest cost was over
$5 million.) Nevertheless, the small success ratio is misleading, because even the threat of a
shareholder proxy contest can lead the executives to seek a compromise to rectify some of the
problems. And, compared to hostile takeovers, proxy contests are outright cheap.

Defensive Strategies
Management can resist hostile takeover and proxy contest attempts through many actions, Management can resist.
Staggered boards
collectively sometimes called shark repellants, such as the following:
virtually eliminate all
hostile takeovers.
Greenmail Management uses shareholders™ money to “buy o¬” the shares of a potential ac-
quirer at a premium.

Golden Parachutes Management lets itself be bought o¬ by the acquirer.

Acquisitions A bigger company is more di¬cult to take over”the “blow¬sh” strategy.

Poison Pills Other shareholders become entitled to purchase more shares at a discount. The
potential raider would then have to repurchase those shares at a higher price.

Fair Value Provisions An acquirer is forced to pay every shareholder the same price, i.e., the
highest price at which shares are acquired.

Supermajority Rules An acquirer needs to obtain more than just a majority of votes to replace
the board.

Litigation Management can delay a potential takeover in the courts, especially if the potential
acquirer is in the same industry, in which anti-trust issues can come into play.

Scorched Earth Management can threaten to sell o¬ corporate assets that are of particular
interest to the acquirer.

New Share Issuance Management can issue more shares to employees and themselves.

Staggered Boards Each year, only a fraction (typically a third) of the directors are up for reelec-
tion. Therefore, no outsider can take control of a company during one annual meeting”
even if you own 100% of the shares before the annual meetings, you can only replace
one-third of the board. The remaining two-thirds will remain in o¬ce, which means that
the company will remain under the control of the existing board for at least one more
year, during which the existing management can do a lot of harm.
¬le=governance.tex: LP
712 Chapter 28. Corporate Governance.

In 2003, a paper by Gompers, Ishii, and Metrick constructed an overall measure of how well
a ¬rm is governed, based on 24 governance mechanisms, prominently including the above
mechanisms to prevent a takeover. A followup paper by Bebchuk and Cohen drilled deeper
and found that staggered boards are the most e¬ective defense. There have been no successful
hostile takeovers of ¬rms with e¬ectively staggered boards.
Not all takeover activity is driven by poor managerial performance. Other reasons for takeovers
Resistance can be
good”especially if it is are industry consolidation and acquisition of monopoly power, desire by acquirers to increase
their own empires, and a desire to take advantage of corporate tax shelters. That is, takeovers
can also occur independently of the target™s managerial performance, and they may increase or
decrease total value and the value of the acquirer. Nevertheless, a takeover almost inevitably
raises the shareholder value of the target. Still, not all managerial resistance by the target is
value-reducing. For example, resistance can and often has forced acquirers to pay more for the
¬rm. Even when it prevents the takeover, the incumbent management often shapes up, e.g., by
making a competing tender repurchase o¬er for its own shares, or by forcing management to
pay out much of its free cash to shareholders.
A particular form of a takeover is the leveraged buyout (LBO). Especially in the 1980s, there
Some history: Leveraged
Buyouts. was a window when small private holding companies were able to borrow signi¬cant amounts
to take over much larger publicly-traded companies in leveraged buyouts (LBOs). The most
prominent LBO was the takeover of RJR Nabisco by Kohlberg, Kravis, Roberts (KKR). Because
the majority of ¬nancing was debt, KKR owned only a small slice of very high-powered equity
and even modest post-LBO underperformance could result in a total investment loss for KKR.
This gave them enormous incentives to get everything right. In the typical LBO, they would
either ¬re existing management or completely restructure the existing management compensa-
tion contracts in order to dramatically improve managerial incentives. Most LBOs created a lot
of value, through better control of agency problems plus tax bene¬ts, and much of it went to
the existing shareholders in the price they received for tendering their shares. However, by the
1990s, public market valuations had generally increased, management generally began to pay
more attention to shareholders, and it became harder and harder to ¬nd companies that could
be purchased cheaply and then improved. But perhaps most importantly, companies learned
how to institute takeover defenses that would be too expensive for a successful acquirer to
overcome. Thus, at least for the time being, corporate governance through external takeovers,
and especially through leveraged buyouts, has faded into the background.

Empirical Evidence
Securities Data Corp (SDC) reports that from 1979 to 2002, there were 40,983 domestic takeovers
Takeover Activity in the
United States. (incl. LBOs), with $7.6 trillion in total value. Takeovers here include both public and private
¬rms, as well as leveraged buyouts. Most of this acquisition activity was solicited by or oc-
curred with the blessing of target management. Such takeovers are called “friendly.” It is
only the “hostile,” or at least “neutral,” takeovers that are likely to be a real threat to poorly
performing management.
Figure 28.1 gives an idea of the relative importance of hostile and neutral takeover activity over
Takeover activity in the
US in the 1980s. time. In the 1980s, there were 8,360 takeovers with $1.2 trillion in total target value. Only
about 1.4% of all takeovers were “hostile”; another 1.2% were “neutral.” But hostile acquirers
managed to take over some pretty big ¬sh relative to non-hostile acquirers: they accounted for
10% of all takeover value in the 1980s (neutral takeovers for less than 0.6%). How does this
compare to the number and value of all publicly traded ¬rms in the United States? In 1982,
there were about 5,500 ¬rms with just over $1 trillion in market value. The 50 or so hostile

Anecdote: RJR, Ego, and Overpayment
The aforementioned bestseller Barbarians at the Gate, also made into a movie, describes the epic takeover battle
for RJR Nabisco between Kohlberg Kravis Roberts (K.K.R.) and RJR management (supported by Shearson Lehman
[now Lehman Brothers]). In October 1988, RJR™s CEO Ross Johnson and his predecessors had mismanaged the
company long enough to allow him to o¬er RJR shareholders the premium price of $17.6 billion in a leveraged
management buyout. This required the resignation of Johnson from the board contemplating the o¬er, which
in turn opened the door to a $20.6 billion countero¬er by KKR. Eventually, KKR purchased RJR for $25 billion,
and Johnson got a $53 million golden parachute. This takeover was also probably KKR™s biggest miscalculation
in that it overpaid for RJR. The prime reasons were personal egos and animosities, which fueled an irrational
bidding war”all to the bene¬t of RJR shareholders.
¬le=governance.tex: RP
Section 28·3. Equity Protection.

Table 28.1. Hostile Takeovers with More Than $5 billion in Target Value, United States to

Announced Target Acquirer Value (billion-US$)
1999/11/04 Warner-Lambert P¬zer 89.2
1988/10/24 RJR Nabisco Kohlberg Kravis Roberts 30.6
1988/10/17 Kraft Philip Morris 13.4
1995/10/18 First Interstate Wells Fargo Capital 10.9
1994/08/02 American Cyanamid American Home Products 9.6
2000/11/13 Willamette Weyerhaeuser 7.9
1990/12/02 NCR AT&T 7.8
2002/02/22 TRW Northrop Grumman 6.7
2000/02/22 Mirage Resorts MGM Grand 6.5
1999/08/11 Reynolds Metals Alcoa 6.1
1985/10/16 Beatrice Co Kohlberg Kravis Roberts 6.1
1985/09/24 General Foods Philip Morris 5.7
1988/01/13 Farmer™s Group BAT PLC 5.2

Source: Securities Data Corp. Not in¬‚ation adjusted.

Figure 28.1. Takeover Activity in the United States

(A) Number of Unfriendly Takeovers (B) Value of Unfriendly Takeovers
Billion Dollars of Hostile and Neutral Takeovers







1980 1985 1990 1995 2000 1980 1985 1990 1995 2000

year Year

(C) Fraction of Unfriendly Takeovers Relative to All (D) Value Fraction of Unfriendly Takeovers Relative to
Publicly Traded Firms All Publicly Traded Firms
Percent Number of Hostile and Neutral Takeovers

Percent Value of Hostile and Neutral Takeovers






1980 1985 1990 1995 2000 1980 1985 1990 1995 2000

Year Year

Source: Securities Data Corp. In the upper diagrams, the total number of both types are circles, the hostile type are
fat dots. In the lower diagrams, these are reported as a percent of the total number and the total market value of
all publicly traded companies on the NYSE, AMEX, and Nasdaq.
¬le=governance.tex: LP
714 Chapter 28. Corporate Governance.

and neutral takeovers in 1982 and 1983 accounted for 0.8% of all publicly traded ¬rms”in one
year...and it was entirely a Kohlberg, Kravis, Roberts e¬ect! This was also the peak of hostile
takeover activity.
In the 1990s, the stock market boomed. General corporate takeover activity also heated up, with
Takeover Activity in the
US in the 1990s. 25,493 takeovers and $4.4 trillion in total target value. But hostile takeover activity declined,
accounting for only 0.2% of all takeovers (down from 1.4% in the 1980s), and neutral takeovers
for only 0.1% (down from 1.2%). In terms of target value, hostile takeovers accounted only for
3.5% (down from 10%), neutral takeovers only for 1.2%. Again, how does this compare to the
number and value of all publicly traded ¬rms in the United States? If we look at the year 2000,
for example, there were about 8,100 ¬rms with about $16 trillion in market value. There were
8 hostile takeovers with about $20 billion in market value, which accounted for just about 0.1%
of all publicly traded ¬rms.
So, does the threat of a hostile takeover discipline managers? It certainly did in the 1980s, and
Does takeover activity
matter? still probably matters a little today. The sheer visibility and novelty of these takeovers were big
enough to prevent the managers of many ¬rms from engaging in the worst abuses. However, as
Table 28.1 shows, KKR and its colleagues seemed pretty satiated after RJR Nabisco”the hostile
takeover threat generally receded after 1990. Any given year now typically sees only about a
handful of hostile takeovers. Their dwindling number indicates that they are no longer the
sword of Damocles that is hanging over”and thereby controlling”corporate management.

28·3.D. Large Shareholders

The right to vote can matter if it is actively exercised by just a few large shareholders.

The Benevolent Role
It is not worth the time of small, diverse shareholders to attempt to vote and/or to in¬‚uence
Only large shareholders
have an incentive to management. The costs of meaningful action and coordination are too high, and the bene¬ts
control agency problems.
to each individual shareholder are too low. (This is an example of the tragedy of the commons,
in which each individual acts in his or her own personal interest, hoping that other individuals
will band together to correct the problems that they all jointly face. But it is in the interest of
each individual to “free-ride,” so this hope is in vain.) Consequently, any active role is most
likely to originate from large shareholders with both enough votes to scare management and
enough value-at-stake to take an active interest. But to become a large shareholder is in itself
costly, because it foregoes the bene¬t of risk diversi¬cation. Typically, the larger the ¬rm, the
smaller the stakes of the largest outside shareholders and therefore the smaller the largest

Anecdote: Bribing Shareholders in Proxy Fights
Karla Scherer led the only successful proxy contest of a major U.S. publicly held company in 1988. As a result,
the company founded by her father in 1933 was sold in June 1989 at a price more than double the value of each
shareholder™s investment the year before, when the proxy contest began.
The most prominent recent proxy contest occurred in 2002, when Walter Hewlett, a Hewlett-Packard (HP) director
and son of cofounder William Hewlett (holding 18% of HP), opposed HP™s acquisition of Compaq. He lost the
proxy vote after Deutsche Bank (DB) switched 17 million of the 25 million shares it controlled”shares of DB™s
clients held in the DB asset management division”in favor of the $22 billion merger. This happened after DB
had become the co-arranger of a new multi-billion-dollar line of credit. In August 2003, the government ¬ned
DB $750,000 for failing to disclose another apparent con¬‚ict of interest to DB™s asset management client. In
a memo to her CEO, HP head Fiorina suggested HP do something “extraordinary” for DB and another ¬rm. HP
paid DB™s investment banking arm $1 million for “market intelligence,” with another $1 million contingent upon
success. DB™s investment banking arm then helped to convince DB™s asset management group of DB™s interest”
and rightly so. During a conference call with DB money managers, Fiorina then reminded DB that their votes
would be “of great importance to our ongoing relationship.”
Some other institutional shareholders held shares in the target, Compaq, and therefore also voted in favor.
(CalPERS, a prominent pension fund and advocate of better corporate governance, voted with Hewlett.) Net, 838
million shares voted in favor, 793 million shares against the deal. Hewlett alleged that HP spent roughly $150
million of shareholders™ money on the proxy ¬ght against him (18% of which he had to e¬ectively pay for).
It is little consolation to the HP shareholderst that the acquisition indeed turned out to be a failure, and that
Carla Fiorina was ¬red by the board in 2005.
¬le=governance.tex: RP
Section 28·3. Equity Protection.

shareholder™s in¬‚uence. Indeed, the evidence suggests that the shareholders tend to be more
dispersed among ¬rms with more severe agency problems.
But even the power of large shareholders is limited. Large shareholder
in¬‚uence is limited.

1. Even if large shareholders have some incentives to control management, it is usually not
pro¬table. A shareholder who owns 5% of a ¬rm su¬ers 100% of the cost of any e¬ort to
in¬‚uence the management, yet reaps only 5% of the bene¬t.

2. Votes are not secret: managers know exactly how their shareholders vote and can seek
retribution later on.

3. If the large shareholder is a mutual fund, it cannot actively seek to in¬‚uence corporate
behavior. If it does, it could run into insider trading laws when it wanted to divest it-
self of its stake upon learning negative information. Therefore, many large institutional
shareholders abstain from actively seeking corporate in¬‚uence.

However, many passive institutional shareholders still can and often do tend to vote their
shares against management if a third party were to seek an active in¬‚uence, e.g., in a proxy
contest. The presence of large blocks of shares, even passive shares, which could potentially
overwhelm the voting power held by management and their allies, is therefore a low-level, but
constant restraint on management.

The Malevolent Role
It is not in the interest of the executives to pick a ¬ght with their largest shareholders. It could Large shareholders may
not seek better
be publicly embarrassing, especially in light of management™s ¬duciary responsibility towards
governance, but better
their shareholders (see below). Instead, most corporate executives seek a cordial arrangement treatment for
with their large shareholders. Special treatment of large shareholders is usually more e¬ective themselves!
than confrontation. Such “VIP” goodies can include special access to information, the sharing of
corporate perks (such as golf outings), special deals (such as sweetheart deals for the ¬rm”or
even the manager of the fund controlling the shares), or greenmail targeted share repurchases
(in which the company management uses shareholder money to repurchase pesky institutions™
shares at a higher price).
Company founders in particular often have a special relation with the company. They often Insiders can also be large
shareholders. Oi wei!
consider the company to be their own and hold enough stock to control it. There is strong
empirical evidence suggesting that founders are often detrimental to shareholders on average:
when the founder of a company suddenly dies, the stock price of the company usually goes
up, not down! As with founders, managers can often become large shareholders, too, and
this is a double-sided sword. On the one hand, they can incentivize managers to be more
eager maximizers of share value: they can bene¬t more. On the other hand, more shares
mean more votes, which in turn means that they are more likely to be able to win any votes.
In perspective, the best control of agency problems by a founding large shareholder may be

Anecdote: CalPERS Top-10 List
The most visible corporate governance activist in the United States is the California Public Employee Retirement
System. CalPERS publishes an annual list of worst corporate governance companies (in its portfolio). Among
its 2003 winners were Gemstar (GMSTE), JDS Uniphase (JDSU), Manugistics (MANU), Midway Games (MWY), Para-
metric Technology (PMTC), and Xerox (XRX). The detailed corporate governance shortcomings make interesting
But even CalPERS rarely takes on Fortune-100 companies (which are most prone to su¬er from agency con¬‚icts).
The reason may not only be political, but the fact that CalPERS™ ownership share in Fortune-100 companies is
too low to make much of a di¬erence.

Anecdote: Graft in Action: Panavision
In August 2002, Business Week reported the end of a two-year drama. In 2001, Ronald Perelman had a 53% stake
in M&F Worldwide Group (MFW), a publicly traded tobacco ingredient company. Perelman initiated an M&F
purchase of Perelman™s Panavision shares at Perelman™s cost of $17/share. At the time, Panavision (PVIS.OB), a
movie camera maker, traded for $4/share. After more than a year in court with a minority shareholder (a hedge
fund that had to pay for its court costs), Perelman graciously agreed to reverse the transaction.
¬le=governance.tex: LP
716 Chapter 28. Corporate Governance.

managerial retirement and death”the new manager is unlikely to obtain the same high levels
of capture immediately after succession.
More generally, such tunneling”transfers from the corporation to a large or controlling stake-
In other countries, large
shareholders may be the holder”is typically not the most important governance issue in the United States. In many
most important
other countries, however, small shareholders fear not so much that managers expropriate all
governance issue.
shareholders, but that large shareholders expropriate small shareholders. For example, in
Europe and Asia, a small number of families control large corporate pyramids, in which ¬rms
often trade with one another. If a family owns 100% of one company and 10% of another
company, it may nevertheless control both managements, and the sale of a $100 million factory
from the latter to the former in exchange for a sweetheart price of $20 million can enrich the
former by $80 million, and the family by $72 million.

The Evidence
The degree of power of large shareholders to restrain management and the degree to which
Some large shareholders
help, other large the presence of a large shareholder aids small shareholders remain a matter of opinion. In
shareholders hurt.
some ¬rms, large shareholders serve a useful role in constraining management, and thereby aid
small shareholders. In other ¬rms, large shareholders help themselves to corporate assets, and
thereby hurt small shareholders. There is some evidence that ¬rms with large public pension
fund investors tend to engage in fewer value-reducing takeovers; that ¬rms with external 5%
owners tend to perform better than ¬rms without such; and that managers in poorly performing
companies are more often replaced when there are large shareholders. But large shareholders
are such a diverse group that it is not possible to generalize further.

28·3.E. The Legal Environment

The United States™ best aspect of corporate governance is probably its legal environment. In-
U.S. law is ever-evolving.
vestors are protected by a set of laws, regulations, and court rulings, plus appropriate legal
enforcement. Much law has come about through court rulings and judicial precedence. This
process has an intrinsic ¬‚exibility, which continues to ¬ll gaps created by new problems. Such
an evolutionary process is more di¬cult to accomplish by statutory law. In civil law coun-
tries, like France or Belgium, where regulations have to be legislated from the top, investor
protections tend to be worse.
To become a successful publicly traded company, a U.S. company usually has to satisfy laws
There are many
regulations that try to and regulations imposed by the state, the federal government, the Securities Exchange Commis-
ensure minimum decent
sion (SEC), the National Association of Securities Dealers (NASD), and the Financial Accounting
corporate governance.
Standards Board (FASB). It also has to try to avoid class action lawsuits, which have bankrupted
more than one company. These needs together set minimum standards on corporate behavior”
especially on appropriate information disclosure and self-dealing”that are not easy to skirt.
Shareholders™ single most important and broadest legal protection is management™s legal ¬du-
Shareholder™s best
protection is ciary responsibility to act on shareholders™ behalves. Black™s Law Dictionary de¬nes a ¬duciary
¬duciary responsibility.
relationship as one “in which one person is under a duty to act for the bene¬t of the others.”
The seminal opinion on ¬duciary duty was written by the New York Court of Appeals in 1984:

Anecdote: Board Courage at Citigroup
Although biased, the PBS series Frontline episode The Wall Street Fix (www.pbs.org) illuminates many of the
con¬‚icts of interest between ordinary shareholders and larger stakeholders. It details how Jack Grubman, star
analyst for the investment bank of Salomon Smith Barney, hyped Worldcom in 2000 to its brokerage™s small
retail investors. At the same time, the CEO of Worldcom, Bernie Ebbers, held a personal $1 billion mortgage
from Travelers. Both SSB and Travelers are owned by Citigroup (C). Ebbers™ wealth (and therefore his $1 billion
mortgage) was closely tied to the Worldcom stock value. In 2005, Ebbers was convicted of corporate fraud.
In a display of less than extraordinary courage, after the indictment of Citigroup for a variety of questionable
activities, the Citigroup board voted its full support and con¬dence in its CEO, Sandy Weill. Business Week was
not so generous: in January 2003, it ranked Sandy Weil as the worst manager in America.
¬le=governance.tex: RP
Section 28·3. Equity Protection.

Because the power to manage the a¬airs of a corporation is vested in the directors
and majority shareholders, they are cast in the ¬duciary role of “guardians of the
corporate welfare.” In this position of trust, they have an obligation to all sharehold-
ers to adhere to ¬duciary standards of conduct and to exercise their responsibilities
in good faith when undertaking any corporate action. Actions that may accord with
statutory requirements are still subject to the limitation that such conduct may not
be for the aggrandizement or undue advantage of the ¬duciary to the exclusion or
detriment of the stockholders.
The ¬duciary must treat all shareholders, majority and minority, fairly. Moreover, all
corporate responsibilities must be discharged in good faith and with “conscientious
fairness, morality and honesty in purpose.” Also imposed are the obligations of
candor and of good and prudent management of the corporation. When a breach
of ¬duciary duty occurs, that action will be considered unlawful and the aggrieved
shareholder may be entitled to equitable relief.

In other words, management™s ¬duciary responsibility primarily limits excessive self-dealing,
especially transactions between the management of a public company and the public company
itself. It does not extend to ordinary business decisions. In fact, the business judgment rule
protects managers against lawsuits if they make poor choices in the execution of most other
company a¬airs. (Otherwise, our litigious climate would paralyze them!)
The importance of enforcement of laws (rather than just what is on the books) is not to be over- Actual enforcement is
important, too.
looked. The United States has strong civil (¬nancial) and criminal penalties and enforcement
for the range of actions detailed in Section 28·2.A. (Although the wheels of American justice
are not perfect and only grind slowly, usually taking years to resolve even clearcut cases, they
do grind.)
Companies have some discretion to choose the laws and regulations under which they are Firms can choose some
operating. For example, ¬rms can choose a particular auditor, stock exchange (with exchange
rules), a particular investment banker, a particular set of warranties, a particular collateral.
Large multinational ¬rms can even choose which country to incorporate in (or reincorporate
in). Of course, a ¬rm that reincorporates itself in Russia, hires a no-name auditor, lists on
the Moscow Stock Exchange, self-underwrites securities, and gives no promises or collateral is
likely not to be able to raise much equity capital.

Anecdote: Disclosure Rights Outside the United States
If you believe the U.S. corporate governance situation is bad, wait until you learn the situation in other countries.
In Germany, until recently, insider trading was legal. Disclosure standards are modest. Minority shareholders
have few rights against self-dealing by majority shareholders, which are themselves often other corporations.
Executives have legal obligations not only to shareholders, but also to employees. But the most amazing fact is
that many German ¬rms are owned by complex webs of other ¬rms, which in turn are owned by yet other sets
of ¬rms. Ultimately, most large publicly traded ¬rms are owned by the banks. The banks in turn are owned
by...themselves! Deutsche Bank holds voting rights for 47.2% of its shares; Dresdner for 59.25%, Commerzbank
for 30.29%. (Source: Charkham (1994).) This makes e¬ective control by the ultimate owners very di¬cult. Many
German banks even own themselves!
But Germany looks like investor heaven relative to Russia. In Russia, shares can be declared void by the board
at any time; majority share owners cannot force an issue onto the corporate agenda; and even physical threats
against pesky shareholders are not unheard of. (And do not look to courts and police for protection: judicial
and political corruption in Russia is rampant.)
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718 Chapter 28. Corporate Governance.

28·3.F. Ethics, Publicity, and Reputation

Ethics is an important factor that constrains many managers (and is often sadly underestimated
Managers are
self-interested, but most by economists). Most CEOs want to do well for themselves, but they want to do so only “within
are not criminals or
the bounds of the normal, accepted, ethical range of actions.” Staying within the bounds of the
unethical people.
ordinary also reduces the concern for negative publicity and legal liability for violation of their
¬duciary duties.
Yet ethical standards are themselves de¬ned by CEOs as a group”and these have slipped over
Ethical standards are
relative and changing. time. In some dimensions, the race seems to have been to the bottom. For example, one hun-
dred years ago, the ¬nancier J.P. Morgan argued that no CEO should make more than 20 times
what the average company employee earns. The average today is almost 200 times. Conse-
quently, being paid 200 times an average worker™s pay does not violate the ethical boundary
of a CEO today. Similar arguments apply to almost every other issue in corporate governance:
if a practice is commonplace among her peers, it is unlikely to violate an executive™s sense of
The desire to avoid negative publicity is also an important constraint on executive compensa-
Lack of transparency
hints that pay packages tion. Negative publicity seems also to be responsible as to why managerial compensation has
are constrained more by
come to consist of many complex components. The complexity renders pay packages fairly
board capture than
opaque to the press. Researchers are often similarly bewildered when they try to determine
driven by incentive
whether executive pay is primarily linked to the need to incentivize managers to seek out corpo-
rate performance or primarily due to managerial board capture. Both seem to matter, but there
is some evidence that obfuscation is particularly important. First, the less-visible retirement
packages are often higher even than reported compensation packages. Second, boards often
change the terms of executive options that would otherwise expire worthless. Both of these
facts indicate that it is not the incentives that are important.
Corporations can also reduce their ¬nancing credibility problem through building reputations.
Reputation sometimes
constrains managers. A manager who has once harmed investors is much less likely to be able to raise capital in the
future. Conversely, a company that has a long history of treating investors well (e.g., paying
dividends and repurchasing shares) often has an easier time raising capital than a company that
has just started up. Reputation may also play a role when a manager is CEO of only a small
company, and has his sights set on being selected manager of a larger company in the future.
To receive a higher call (with more opportunities to become richer), the manager must constrain
his self-interest for a while. One problem with reputation as an agency control mechanism is
that managers close to retirement no longer care as much about their reputations as they care
about their severance packages. Most CEOs retire, rather than graduate to bigger companies.
¬le=governance.tex: RP
Section 28·3. Equity Protection.

28·3.G. Conclusion

Capitalism will not collapse because of managerial theft and misbehavior, even if corporate gov- Various mechanisms try
to constrain agency
ernance in many public corporations is largely broken”perhaps because theft can only be so
large. Agency control works in some companies and fails in others. Like the agency problems
themselves, the solutions to agency problems are complex. In broad strokes, today™s mech-
anisms involve the combination of corporate obligations (promises by the corporation), legal
obligations, and informal and ethical obligations. Ultimately, in today™s system, if executives
have no scruples, even the best legal and corporate systems are unlikely to succeed in curbing
all misbehavior. But even though capitalism as a system will not collapse over poor corporate
governance, individual economies may. Arguably, a country that has better corporate gover-
nance is likely to outcompete other countries and prosper. It is a matter of great importance
to economic competitiveness to seek to improve it.
Solve Now!
Q 28.5 Does the desire to raise equity capital control managerial agency con¬‚icts?

Q 28.6 What are some of the reasons why corporate boards may have limited ability to control
the CEO? What other roles may boards serve?

Q 28.7 What are some of the reasons why proxy and takeover contests may have limited ability
to control the CEO? How is a shareholder proposal di¬erent?

Q 28.8 What are some of the reasons why large shareholders may have limited ability to control
the CEO?

Q 28.9 What are some of the reasons why the rule of law may have limited ability to control the

Q 28.10 What are some of the reasons why ethical standards may have limited ability to control
the CEO?

Anecdote: The fox guarding the hen house: The N.Y.S.E.
It is well-known that the New York Stock Exchange (NYSE) is not a publicly traded company, but is owned by its
members, primarily by investment banks like Goldman Sachs. The members appoint the NYSE board. But it is
less well-known that the NYSE is an odd creature in another respect. It is both a stock exchange and a regulatory
agency. The SEC relies heavily on the NYSE to ensure good corporate governance among its members and its
traded ¬rms, which represent almost all large U.S. corporations (with the exception of the technology sector).
As guardian of good corporate governance, arrangements at the NYSE are particularly relevant”but remarkably
con¬‚icted. The NYSE board decides on its chairman™s compensation package. The chairman regulates its
members. The NYSE members appoint the board. The board appoints the chairman and sets the chairman™s
pay package. The chairman regulates the members who appoint the board. The board pays the chairman. The
chain is circular.
In August 2003, the media found out that Richard Grasso, the NYSE Chairman, held a retirement package
worth $140 million”about four times the annual pro¬ts of the NYSE. The media later found an additional $48
million in pay, which Grasso then publicly and graciously declined. (But he never did so in writing.) After more
press digging, it was revealed that Grasso also helped pick the executive compensation committee. Many large
institutional shareholders then joined the chorus, publicly demanding Grasso™s resignation. On September 17,
2003, Grasso ¬nally bowed to the board™s discontent”but he did not resign outright. Meeting with his lawyers,
he learned that by forcing the board to terminate him (rather than by resigning), he would receive an additional
$57.7 million, in addition to the $140 million deferred compensation”which he did.
In 2004, Grasso sued the NYSE for $50 million more, because his contract of 2003 contained a clause that
forbade exchange executives from making any statement against Grasso if he left the NYSE. In March 2005,
Grasso further sued the former chairman of the exchange™s compensation committee for having overseen the
approval of Grasso™s pay package. As of 2005, Grasso still had one suit against the exchange for $50 million,
but he has received his $193 million in compensation and pension bene¬ts. (In other litigation, the New York
Attorney General seeks to recover $100 million from Grasso as “excessive compensation.”)
¬le=governance.tex: LP
720 Chapter 28. Corporate Governance.

Q 28.11 What can an executive do to resist a takeover? What has been the most e¬ective anti-
takeover device?

Q 28.12 What is an LBO? How common are LBOs?

Q 28.13 What fraction of takeovers are hostile?

Q 28.14 Is the presence of large shareholders always good from an agency perspective?

28·4. Debt Protection

Equity payo¬s depend very sensitively on good management control and actions and accurate
Equity needs constant,
expensive supervision. accounting (veri¬cation). Even if they are ¬rmly in charge, equityholders have the unenviable
task of determining whether poor performance is the fault of management, the market, or both.
Unlike equity, creditors do not need to play a large role in the day-to-day operations of the
Debt has a much easier
task: collect promised company in order to receive most of their due. Ascertaining the value of collateral is cheaper
amounts, or seize assets.
than ascertaining the value of equity (with its future growth options). And if cash is not paid
when promised”regardless of whether it is because the market environment is bad, because
management has performed poorly, or because management just hides assets”the company
falls into automatic default (usually bankruptcy and/or corporate liquidation), and creditors
can take control of the company and/or the collateral. Therefore, creditors need not spend
much time and money investigating managers.
We have already discussed in Chapter 27 that creditors usually demand and receive covenants,
Some typical covenants.
by which the ¬rm must live. Covenants may include collateral, priority, the naming of an au-
ditor, the speci¬cation of minimal ¬nancial ratios (e.g., dividend payout ratio), and many more
terms. Default occurs when covenants are not met. Importantly, coordinated creditor action
upon delinquency is not required, because such mechanisms are designed at inception. (If the
creditor is a single large bank, this is not necessary.) In the case of a public bond, the covenants
designate a trustee to oversee performance of covenants. The trustee has the obligation to de-
clare a bond in default when the covenants are not met. (The process is mechanical.) Therefore,
in contrast to equity holders, bond holders do not commonly su¬er from free-rider problems.
Management will try to avoid default like the plague. The reason is not just that equity own-
Bankruptcy is really bad
for management. ers, on whose behalves managers supposedly act, lose access to the ¬rm™s future projects.
The more important reason is that corporate management is replaced in virtually all bankrupt
companies. This gives management and shareholder-owners an enormous incentive to avoid
Although there are some escape mechanisms that permit management to manipulate the cove-
Manipulation of
bondholder rights is nants, these are rare and slow. The ¬rst such mechanism is a “forced exchange o¬er,” in which
possible, but it is not
managers set up a prisoner™s dilemma that makes it in the interest of every individual bond-
holder to exchange their current bonds for less worthy bonds but of higher seniority”even
though it is not in the bondholders™ collective interest. The second mechanism is a covenant
amendment, which must be approved by the bond trustee and voted on by bondholders. The
third mechanism is asset sales or divisional splits, which require major corporate surgery. For
example, when Marriott Corporation announced that it would split into two companies (hotel
operator Marriott International, MRT, and a real-estate investment trust Host Mariott, HMT) in
1992, its share price rose by 10%. Marriott™s bondholders sued, because the old Marriott debt
now would be owed only by one descendent, Host Marriott. Moody™s Special Report covering
1970“1992 stated on page 4 that:

Perhaps the most notorious fallen angel of the year was Marriott Corp., which alone
accounted for $2.6 billion of downgraded debt. In October, Marriott announced a
¬le=governance.tex: RP
Section 28·4. Debt Protection.

controversial spin-o¬ that would relieve the pro¬table hotel operations business of
the heavily indebted real estate and concessions business. Such a move would have
the e¬ect of creating one very healthy and essentially debt-free company, Marriott
International Inc., and another substantially weaker debt-laded ¬rm, Host Marriott
Corp. While issuer-bondholder talks are ongoing in the Marriott case, investors
worry that such lopsided spin-o¬s may become more popular in the future.

Nevertheless, these are the exceptions rather than the rule. It is generally much harder for
management to escape bondholder discipline than it is for them to escape stockholder disci-
pline. In turn, this can even help shareholders”even though liquidation almost always hurts
shareholders, the threat of future liquidation upon poor managerial performance can motivate
managers and thereby help dispersed public shareholders up-front.
We have earlier talked about how large shareholders cannot only discipline managers but also The role of large
extort special privileges. A similar issue can arise with creditors. That is, although we have
discussed primarily the case in which creditors cannot trust corporations, the opposite can also
be the case. (And it can just as much prevent the ¬rm from obtaining viable debt ¬nancing.) A
creditor may be able to pull its line of credit and thereby threaten management or expropriate
the ¬rm™s equity (receiving control of the ¬rm). Banks attempt to build a reputation for not
doing so in order to reduce such borrower concerns.
Solve Now!
Q 28.15 Why does management often prefer to avoid ¬nancial distress?

Anecdote: Creditor Protection Outside the United States
In the United States, management can ¬le for Chapter 11 protection, which can delay the turning over of assets
to creditors. This option does not exist in many other countries. For example, in Germany, creditors can force
practically immediate liquidation of the ¬rm upon non-payment. As a result of poor shareholder protection and
strong creditor protection, many German companies are heavily creditor-¬nanced: it is far more di¬cult for
them to ¬nd shareholders than it is to ¬nd creditors. Many of the largest German companies remain founding-
The worst creditor protection usually occurs in the case of sovereign debt (debt issued by countries). There
is very little other than a country™s desire for a good name and its foreign assets that prevents it from simply
repudiating its debt. For example, Argentina owed about $220 billion in 2001, with required repayments of $22
billion a year”during the worst economic crisis the country had ever experienced. Interestingly, in July 2000,
an Argentinian Judge named Jorge Ballestero sent down an intriguing ruling on the foreign debt: the ruling
attributed responsibility for the debt to the civil servants during the previous dictatorship that contracted it
and co-responsibility to international organizations like the IMF, who approved the loans, now declared illegal
and fraudulent.
Would you lend your money to a country?
Source: odiousdebts.org.
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722 Chapter 28. Corporate Governance.

28·5. The Effectiveness of Corporate Governance

28·5.A. An Opinion: What Works and What Does not Work

In the real world, it is impossible to design corporate contracts and arrangements that result
Give up all hope”or
don™t give up hope. in perfect (“¬rst-best”) managerial behavior. If we want to maximize wealth, we have to live
with imperfection (“second-best”). In equilibrium, we must trade o¬ the advantages of being
public (such as access to more capital and better diversi¬cation) against the disadvantages
(managerial misbehavior). This is not to condone the latter: just because some shoplifting may
be unavoidable does not mean it is right.
Our ultimate trade-o¬ is achieved not through one, but through a variety of mechanisms. Cor-
There are many
mechanisms that work porate governance consists of many components, of which the corporate and legal structures
in concert. Now comes
are perhaps the most important. Although the many mechanisms all need one another, we can
my opinion.
wonder what really works. This is a matter of some dispute among economists, so my own
view must color my assessment here.
Even if corporate governance in the United States seems to work better than it does elsewhere,
self-governance in the it is largely broken. Corporate boards and institutional shareholders have only a modest con-
United States is almost
straining e¬ect on CEOs in the ordinary course of business. A manager who starts out with
totally broken.
a couple of good years and who is bent on taking over control of the company will encounter
only mild internal resistance. Once entrenched, it is not corporate self-governance, but only
legal and public relations concerns that are likely to constrain the manager. Fortunately, our
corporate governance problems are not big enough to destroy most of the wealth created by
our multi-billion dollar publicly traded companies, and they won™t bring down capitalism, ei-
ther. But in terms of the wealth siphoned o¬ from the corporate sector into individual pockets
and in terms of bad decisions taken, the problem is not modest.
Unfortunately, the ethical aspect of corporate governance has also begun to erode, perhaps
Ethical constraints are
decaying or decayed. because the other corporate governance aspects have deteriorated. For example, even as late
as 1980, the typical manager earned only 40 times what the average employee earned. Most
managers would have felt uncomfortable earning more than 100 times. Nowadays, the average
Fortune 500 executive earns over 400 times what the average employee earns, and few exec-
utives would deem pay packages of $100 million or more to be obscene. The standards of
appropriate managerial behavior today are not the same as they were in the past”and the past
itself is nowhere near as rosy as it is often painted.
Consequently, it seems to be the legal structure in the United States that is our saving grace.
Legal protection is the
only half-way intact The standard of disclosure; the requirement of ¬duciary responsibility; the e¬ectively enforced
prohibition of theft, fraud, and insider trading; the personalized legal liability; and the strong
enforcement of its laws all contribute to a viable governance framework. Oddly, this is enough
to rank the United States at the top of locales for equity investors.
This situation is perplexing to us economists. Our perspective is usually that much of what
Legal protection as a
corporate governance the government touches comes out for the worse. Private companies usually tend to do better.
mechanism carries a real
Yet, it is precisely the legal structure in the United States that has become the most e¬ective
danger: in the future, it
corporate governance mechanism. So, should we ask the government to take a more active
could hurt more than
role in corporate a¬airs? If so, what is the risk that more government could end up as a cure
worse than the disease? The appropriate remedy for managerial abuse is a vexing and thorny
¬le=governance.tex: RP
Section 28·5. The E¬ectiveness of Corporate Governance.

28·5.B. Where are we going? Sarbanes-Oxley and Beyond

One might be tempted to just leave a system alone that seems to have worked for centuries. The corporate scandals
of 2001“2003 ironically
But this system was not static either. There is also a real danger that if no action is taken and
are not the result of
corporate governance becomes worse in the United States than in other countries, investors inadequate corporate
may wander o¬ to other locales. The recent corporate scandals in the United States have governance laws, and
reform efforts are
helped to highlight the need for corporate governance reform. Ironically, these scandals were
unlikely to prevent them
the results of already illegal actions, and many perpetrators may end up spending many years from repeating.
in prison. Recent reforms will not eliminate such scandals in the future: Just as bank robberies
exist despite laws against bank robbery, so will illegal managerial looting continue despite laws
against it. Fortunately, some good may yet come out of the current attempts at corporate
The main legal regulatory functions in terms of corporate governance reside with the SEC and Reforms are proposed
by Sarbanes-Oxley, the
the stock exchanges. The Sarbanes-Oxley Act of 2002 further reinforces this system. In line
with this act, the stock exchanges are trying to tighten their rules for listed companies. (The
NYSE enforces a tighter set of corporate governance rules than NASDAQ.)
Most of the post-Enron changes seek to strengthen the independence and function of the corpo- Listing the current
changes to corporate
rate board, especially insofar as the audit, executive compensation, and nomination committees
are concerned. Here is a selection of the most important reforms of 2003:

• There is now a clear de¬nition of what an independent director is: an individual who
has no current or recent material relationship with the company. (Note that independent
board members can still have close relationships with the CEO.)

• Independent directors must meet among themselves in regularly scheduled executive
sessions without management.

• A large part of the Sarbanes-Oxley Act pertains to the audit committee, as the Act itself
was sparked by accounting scandals:

“ The audit committee, which checks over the company™s ¬nancial reports, must con-
sist entirely of independent directors. There are additional special rules for the audit
committee pertaining to large shareholders.
“ The audit committee must have choice of, oversight of, and compensation respon-
sibility for the company™s auditors. It can engage additional advisors, and it must
institute procedures to handle btoh complaints and whistle-blowers.
“ External auditors are also to be limited in the amount of consulting work they can
do for companies, which has historically been a great source of con¬‚ict for public
auditors. In addition, the audit committee must approve any remaining non-audit
consulting work by the auditor.
“ The audit committee must identify which of its members is a ¬nancial expert, and at
least one is required.
“ The audit committee has “code of ethics” responsibility.
“ Auditors must be rotated on a regular basis in order to reduce the tendencies of
relationships between ¬rms and auditors to become too cozy. (Of course, this has
costs, too: new auditors have to ¬rst learn more about the ¬rm, and may be less apt
in detecting unusual behavior.)

• The C.E.O. and C.F.O. must certify to the audit committee the accuracy of the company™s
¬nancial reports/condition. (This is a new feature of Sarbanes-Oxley”or is it? Executives
were responsible for the reported ¬nancials of their companies even before its enactment.
It made for good television, though.)

• Attorneys must alert the SEC if they learn of credible evidence of breaches of ¬duciary
duty or of United States securities law.
¬le=governance.tex: LP
724 Chapter 28. Corporate Governance.

• Companies can select the members of their executive compensation committee and board-
nominating committee, but these committees must be majority independent (NASDAQ)
or fully independent (NYSE).

In addition to these new legal regulations, there have also been a whole range of institutions
that have proposed “best practice” guidelines for corporate governance. The most prominent
are the GM Board Guidelines (since 1994), the American Law Institute Principles (since 1992),
the Business Roundtable Principles (since 2002), the National Association of Corporate Directors
Report (since 1996), the Conference Board Recommendations (since 2002), the CalPERS Princi-
ples/Guidelines (at least since 1998), the Council of Institutional Investors Principles and Positions
(since 1998), the TIAA-CREF Policy Statement (since 1997), the AFL-CIO Voting Guidelines (since
1997), and the OECD Principles/Millstein Report (since 1998).
Many of these reforms have positive aspects, but there are also many negative ones. Sarbanes-
Here is what I think is
missing. Oxley was more image then substance, and where it had substance, it focused on process over
outcome, and required yet more bureaucracy. Many foreign corporations that had cross-listed
on the New York Stock Exchange are currently evaluating whether the added Sarbanes-Oxley
cost is so high that they are better o¬ delisting again. There have been a good number of other
reform proposals that have been put forward. Here are the four suggestions that I most like:

1. Ira Millstein has proposed that the position of Chairman of the Board should be separate
from that of Chief Executive O¬cer. It should be obvious that if the Chairman is also the
CEO, the board at best can only struggle to assert in¬‚uence over management, rather than
direct management to act in the interest of shareholders. Today, in executive circles, a
company that has a separate chairman is viewed as not trusting its CEO. It must become
an accepted corporate norm for these two positions to be separate.
The argument against separation, mustered by many CEOs, is that it would cost them
time and e¬ort to deal with a separate chairman. It is in e¬ect the argument that a benign
dictator is better than checks and balances. This is correct. Good governance”a system
of good checks”does not come for free. It can cost money if management is good, but
save money if management is bad”which, after all, is the whole point of governance.
Good governance is not good management. Good governance is the mechanism to reign
in management that is bad.

2. The voting system could be changed to a proportional system, in which minority share-
holders are assured some representation. If a shareholder with 10% of the shares can
obtain 10% of the seats if so desired, then large institutional shareholders could create
mechanisms of “professional trustees” who are not beholden to management.

3. Any insider trading should be disclosed before a trade, not after it.

4. Large, publicly traded companies could be forced to disclose their tax ¬nancials. This
would reduce their incentives to overstate earnings.

The government would not need to legislate governance reform. Instead, it could tighten the
Better than forcible
regulation is legal liability of corporations and individuals that do not follow these recommendations, and
o¬er a “safe harbor” to corporations and individuals that do follow their recommendations.
This would put the appropriate pressure on ¬rms to follow them, without absolutely requiring

Anecdote: The Corporate Governance Consulting Industry
A recent phenomenon is the emergence of corporate governance consultants. For example, Georgeson publishes
an interesting year-end wrap up of shareholder proposals and proxy contests. Unfortunately, some corporate
governance consultants not only publish ratings of how well publicly traded companies are governed, but
also sell “advice services” to companies. Not surprisingly, following the consultants™ advice, the client tends
to improve in the consultant™s rankings. It looks like the corporate governance consultant has some serious
corporate governance issues!
¬le=governance.tex: RP
Section 28·6. Summary.

Solve Now!
Q 28.16 What are the main Sarbanes-Oxley reforms?

28·6. Summary

The chapter covered the following major points:

• Control rights are necessary components of any security in order to defend their cash
¬‚ow rights.

• Managers have the incentive to act in their own self-interest, not necessarily in the interest
of shareholders and creditors.

• Mechanisms have evolved to reduce or rein in managerial theft”such as corporate takeovers,
large shareholders, corporate boards, legal environments, ethics, and debt.

• There are a number of possible mechanisms to improve corporate governance in the
United States.

Special thanks to Florencio Lopez-De-Silanes, Paul Macavoy, Ira Millstein and Holly Gregory. Holly authored a legal
description of Sarbanes Oxley that is synthesized here. www.weil.com/weil/corpgov_frames.html. contains newer
versions of this document.
¬le=governance.tex: LP
726 Chapter 28. Corporate Governance.

Solutions and Exercises

1. For debt, it is the right to force bankruptcy if covenants are violated. For equity, it is the right to vote.
2. Illegal: Theft, fraud, insider trading, transfers, bribes. Legal: Empire building, perks, excessive executive pay,
entrenchment, friendship and loyalty, and the incentives to drive down the ¬rm value in order to purchase
the company on the cheap.
3. Right around the time of the ¬rm going public. The entrepreneur internalizes all future agency con¬‚icts. To
the extent that money will be diverted from owners in the future, these owners will be willing to pay less for
the ¬rm today. For a numerical example, see the text.
4. First, it is impossible to think of all future contingencies that could happen, and therefore should be consid-
ered in the charter. Second, the entrepreneur will care primarily about agency con¬‚icts soon after the IPO,
and pretty much ignore what may happen many decades later.

5. No. Quite the opposite can happen”seasoned equity o¬erings can be a mechanism by which managers enrich
themselves at the expense of the company that they are running.
6. The CEO knows the ¬rm better, and through judicious choice of information, control the agenda. The CEO is
often the board chair. Elections for the board are usually by slate and uncontested. Outsiders are often CEOs
themselves. As to other roles, advice and relationships as well as aid in management succession may play a
7. It is very costly to execute a proxy and takeover contest. A typical premium may require a premium as
high as 20%”worthwhile only if the current management commits the most egregious breach of appropriate
behavior. Shareholder proposals are not binding.
8. In large, widely held publicly traded corporations, Even large shareholders typically hold only small fraction
of the shares. Thus, they will not invest too much e¬ort, because they do not receive 100% of the bene¬ts
from lobbying. Moreover, management will ¬nd out whether a shareholder voted against them.
9. It regulates only the most egregious violations of ¬duciary duty. It does not extend to “business judgment”
10. The standards are themselves set by the behavior of CEOs as a group. Moreover, ethical standards tend to
be higher when information is publicly available, and not everything is publicly reported.
11. See the list in Section 28·3.C. Staggered boards have virtually eliminated hostile takeovers.
12. An LBO is a leveraged buyout, i.e., one that is ¬nanced with a signi¬cant amount of debt. They were very
common in the 1980™s, but have largely faded.
13. Around 1 percent.
14. The presence of large shareholders can be very bad from an agency perspective if these shareholders use
their voting power to arrange special deals for themselves.

15. Even if the company continues to exist, management is usually replaced!

16. Independent directors are now clearly de¬ned. They must meet by themselves regularly without manage-
ment. The audit committee and the independence of auditors was beefed up. The CEO and CFO must certify
the accuracy of the company™s ¬nancial reports. Attorneys must report certain breaches of ¬duciary duty
or securities laws. And the executive compensation and board-nominating committees must be majority

(All answers should be treated as suspect. They have only been sketched, and not been checked.)
Part V

Putting It All Together “ Pro Formas

(A part of all versions of the book.)

Corporate Strategy and NPV Estimation With Pro
Forma Financial Statements

Projecting Financial Statements.
last ¬le change: Mar 19, 2006 (11:05h)

last major edit: Apr 2004, Feb 2005, Mar 2006

A pro forma is a model of a hypothetical future scenario. In our context, a pro forma usually
means a model of the ¬nancial performance in this hypothetical scenario.
In a sense, pro formas are what corporate ¬nance is all about”the standard way in business to
think about and propose ¬nancing or investing. For example, when you propose a new project
to your boss, to the board of directors, or to an external venture capitalist, you will almost surely
be asked to produce a business plan. The most critical part of this business plan will have to
be your “pro forma” ¬nancials. These ¬nancials will be used as the baseline for discussion and
valuation of your proposed project.
Managers and entrepreneurs are not the only producers of pro formas. Analysts for major
investment banks or for ¬rms seeking acquisitions or mergers also have to produce pro formas
to back up their analyses of corporate value. Their task is both easier and harder than that of the
entrepreneur: analysts can rely on historical ¬nancial statistics and sometimes a stable history
upon which to base their pro formas, but they also often lack the detailed knowledge of the
business internals and of the corporate intentions that the internal managers and entrepreneurs
would have.
Every business is di¬erent, and thus every pro forma is di¬erent. Still, this chapter tries to
give some guidance to the process of creating pro formas. In this chapter, you will learn how
to produce a pro forma analysis of PepsiCo. We will construct pro formas from a number
of di¬erent perspectives”that of an analyst valuing a privately traded company that has no
market value yet (equivalent to the perspective of an analyst who values a publicly traded
company for the purpose of assessing whether a leveraged buyout might make sense), that of
an analyst proposing a capital structure change for a publicly traded corporation, and that of
an economist who has the advantage of hindsight.

Anecdote: Pro Forma
According to Merriam-Webster, pro forma is a Latin term meaning “for form” and dated ca. 1580. Pro forma
has two de¬nitions: “provided in advance to prescribe form or describe items”; and “made or carried out in a
perfunctory manner or as a formality.” In many (rejected) business plans, the latter may be a better description
than the former!

¬le=proformas.tex: LP
730 Chapter 29. Corporate Strategy and NPV Estimation With Pro Forma Financial Statements.

29·1. The Goal and Logic

To repeat, a pro forma is a model of the ¬nancial performance in a hypothetical future. Creating
Detailed pro formas help
us think about the a pro forma is a challenge similar to what you encountered in earlier chapters, where you had
to compute a project™s present value. You needed to understand how everything ¬ts together”
the expected cash ¬‚ows, the appropriate cost of capital, the role of the corporate and capital
structure, the agency con¬‚icts. The main novelty of a pro forma is that you now need to forecast
the future in the context of the ¬nancial statements, rather than just in the context of the NPV
formula. Creating such a full pro forma is not work for nothing: it will help impose some
discipline and structure on your thinking about the design and value of the proposed project.
It forces you to think about “details” such as what you believe sales and costs will be, how
you will manage working capital, how quickly your contribution to corporate earnings can turn
positive, whether taxes will be an important factor, and so on.
No ¬nance professor would dispute the importance of pro formas, but we are often reluctant
But forecasting for pro
formas is hard and to teach much about it. The cynical view is that constructing a pro forma is di¬cult, and we
different from business
¬nance professors naturally prefer the “easy” tasks! The less cynical view is that there are at
to business.
least three good reasons for our reluctance:

1. Idiosyncracy: In contrast to the many beautifully simple, elegant, and universal theoretical


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