SESSION 8:

CORPORATE GOVERNANCE I

MODERN FINANCE AND CORPORATE FINANCE

NIKOLAOS KAVADIS
nk.ccg@cbs.dk
 INTRODUCTION
What is corporate governance?
• The system of incentives, controls, and regulations, designed to address conflicts of interest
 CG is about conflicts of interest and attempts to minimize them, if not solve them
 System of checks and balances that trades off costs and benefits: No one structure works for all
firms in all countries.

• Types of conflicts:
o Owners/shareholders and managers (agency problem “type 1”)
o Majority shareholders and minority shareholders (agency problem “type 2” or principal-principal problem)
o Shareholders and other stakeholders, e.g., debtholders (agency problem “type 3”)

• Object of conflict: Resources, including financial

 How resources will be deployed/allocated among different stakeholders

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 INTRODUCTION

Block owners (e.g.,

Debt holders
Families, States)
More effective “Pressure-
Possible PP monitoring sensitivity” when
problem owners (alignment
to managers)
Delegation (possible
Dispersed (smaller) PA problem)
Managers
owners
Possible alliance
when takeover
threat
Protection

Protection Employees
Legal system /
country institutions

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 INTRODUCTION

What is corporate governance? (2)

• Existence of a variety of stakeholders (shareholders, managers, customers, among others)

 Existence of a variety of stakeholders doesn’t mean a balanced approach to addressing interests.

• What the purpose of the corporation is?

 The answer to this question that one provides shows what goals/interests the corporation (which
stakeholders) has to serve in priority.

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 INTRODUCTION
What is corporate governance? (3)

• Long-standing emphasis in shareholders’ interests, i.e., shareholder value maximization (SVM)

 Share price as main criterion of value

• For a long time, CG was often narrowed down to ensuring shareholders getting a return on their investment
 Mostly studied agency problem: The one between shareholders and managers, deriving from the
separation of ownership from control of corporations
 Provide credible evidence that shareholders will get a return

• More recently, attempts to re-balance CG as a more inclusive, stakeholder-oriented system

• Including other metrics as well, e.g., customer and employee satisfaction, asset sustainability (see ESG)

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 INTRODUCTION

What is corporate governance? (4)

• Various approaches/assessments of agency conflicts

o Exist as long as agents do not fully internalize the cost of their actions (e.g., how we might order at a restaurant when
we pay vs. when the company is paying)
o Interests’ misalignment, in particular, because of different risk preferences (see agency theory)
o Interpretation problems in carrying out the delegated task

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 OWNERSHIP AND CONTROL

Separation of ownership from management

• Contrasting evolution of ownership structures between the ones we observed in the US and in other
countries, e.g., continental Europe, as of the 19th century.

• Ownership of US firms became progressively dispersed

o From few private owners (families) to dispersed market ownership

• In those firms, owners no longer presided or had control

o They appointed professional managers to manage their wealth

• The expansion of this type of firm (public corporation), and the increase of its size and complexity made
managers’ role increasingly important.

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 OWNERSHIP AND CONTROL

“Retain and reinvest” as a governance logic

• Retain revenues (resources) and reinvest to generate/acquire more of them.

• Focus on corporate expansion (diversification) through internal growth and/or M&As

o Rise of the conglomerate corporation in the 1950s-1960s

• Corporate managers having legitimate control over corporate resources: Considered as having the expertise to
efficiently allocate them.

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 OWNERSHIP AND CONTROL

Change in the governance logic (1)

• Firms grew too big with too many divisions/businesses

• Growing inefficiencies, low performance in the 1970s
• Problem exacerbated by
o Unfavorable economic environment (crisis)
o Emerging international competition, especially the one coming from Japan

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 OWNERSHIP AND CONTROL

Change in the governance logic (2)

• Simultaneous financial deregulation (further development of financial markets): Disintermediation, new

financial instruments
• Pension funds and insurances’ entrance in corporate equity capital
• Progressive transfer of shareholding from individual to institutional investors who have greater
collective power to promote their interests, i.e., SVM
o Individual ownership from 93.1% (1945) to 25.4% (2007)
o Pension/Mutual fund ownership from 0.8% (1945) to 48.3% (2007)

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 OWNERSHIP AND CONTROL
Change in the governance logic (3)

• Corporate inefficiencies attributed to managerial self-interest

o Conflict of interest between shareholders and managers over resource control and allocation (agency problem)
o Potential for mischief when managerial interests diverge from the ones of owners: Willingness to extract higher rents
than otherwise accordable by the owners

• Risk as a main reason for interests’ divergence between managers and shareholders:
o Shareholder risk neutrality: They can spread their risk through various equity holdings
o Managerial risk aversion: They invest most if not all of their (human) capital in one firm: Managerial interest to invest
in businesses (1) matching their expertise; (2) unrelated / counter-cyclical between them

• Organizations as legal fictions serving as nexus for a set of contracting relationships between individuals
• Belief in the market as more efficient than firms for resource allocation: Shareholders perform critical
economic functions (e.g., investing, risk-bearing); suggestion that cash to be given to them.

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 OWNERSHIP AND CONTROL

“Downsize and distribute” as a new governance logic

• Primacy of SVM in corporate governance: Firms mainly evaluated by their stock price
• Predisposition against managerial control over resource allocation
• Financial market activity against diversified firms/conglomerates
o Corporate restructuring: Buyouts of parts of conglomerates, hostile takeovers, divestments
o 1980s: Emergence of market for corporate control, to extract free cash flow from managerial control
o New legitimate ways to use cash: distribute dividends or repurchase shares

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 OWNERSHIP AND CONTROL
Cash distributions to shareholders (dividends and share repurchases), 1980-2013 (data from
Compustat)

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 PAYOUT POLICY
Context reminder: When a firm’s investments generate FCF, the firm must decide how to use that cash. If the
firm has NPV>0 investment opportunities, it can reinvest the cash.
• Many young rapidly growing firms reinvest 100% of their CFs in this way. Mature profitable firms often find
that they generate more cash than they need to fund all of their NPV>0 investment opportunities.

• When a firm has excess cash (=FCF), it can hold those funds as part of its cash reserves or pay the cash
out to shareholders.
 Why some firms build large cash reserves but others pay out excess cash?

• If the firm decides to pay the cash out, two options: Pay dividends or repurchase shares
• These two decisions/alternatives represent a firm’s payout policy, which is shaped by market imperfections,
such as taxes and asymmetric information between managers and investors.
 Why some firms prefer one or the other option?

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 PAYOUT POLICY

Free Cash Flow

Retain Pay out

Reinvest Reserve Dividends Repurchase

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 PAYOUT POLICY
Dividends = Cash outflow for the firm, as it tends to reduce the firm’s current or accumulated retained
earnings.

• The declaration date: The board sets the amount of dividend (the amount per share) and the date to be paid.
After the declaration, the firm is legally obligated to make the payment.
• The (formal) payment date = The record date (≠ than the payable or distribution/reception date). An investor
must purchase stock at least 3 days before the record date to receive the dividend.
• The 2 business days prior to the record date = Ex-dividend date.

Usually, dividends are paid at regular, quarterly intervals with little variation in the amount.
Occasionally: Special dividend, which tend to be much larger than a regular dividend.

Stock split or stock dividend = The firm issue additional shares rather than cash to its shareholders. E.g., a 2-
for-1 stock split doubles the number of shares but the dividend per share is cut in half.

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 PAYOUT POLICY
Share repurchase

• Open Market Repurchase = Most common way of repurchase: A firm announces its intention to buy its own
shares and then proceeds to do so like any other investor. The firm may take a year or more to buy the shares,
and it is not obligated to repurchase the full amount it originally stated.
• Tender Offer = A firm offers to buy shares at a pre-specified price during a short time period – generally
within 20 days. The price is usually set at a substantial premium (typically 10%-20%) to the current market
price. If shareholders do not tender enough shares, the firm may cancel the offer and no buyback occurs.
• Targeted repurchase = A firm purchases shares directly from a major shareholder (and negotiates directly
with the seller)
o It may occur if a major shareholder desires to sell a large number of shares but the market for the shares is
not sufficiently liquid to sustain such a large sale without severely affecting the price.
• Greenmail transaction = If a major shareholder threatens to take over the firm and remove its management,
the firm may eliminate that threat by buying out the shareholder.

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 PAYOUT POLICY

Comparison between dividends and share repurchase

How do firms choose between the two alternatives? In perfect capital markets, payout method does not matter.
Example:
A firm has 10 M shares outstanding. $20 M in excess cash and no debt. Expectation of additional FCF of $48 M
per year in subsequent years. Unlevered cost of capital = 12%
What is the enterprise value?

Enterprise Value = PV(Future FCF) = $48 M / 12% = $400 M.

Including the cash, the total goes up to $420 M.

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 PAYOUT POLICY
Comparison between dividends and share repurchase (2)

The board may decide to pay out to shareholders $20 M. Three policy alternatives:

1. Pay dividend
With 10 M. shares outstanding, it can pay $2 dividend immediately.
Given expectations of future FCF = $48 M per year, anticipate a dividend pay of $4.80/share each year after.
What’s the share price just before and after the stock goes ex-dividend?

No debt, equity cost of capital = unlevered cost of capital = 12%

Just before the ex-dividend date, the stock is said to trade cum-dividend (“with the dividend”) because anyone
who buys the stock will be entitled to the dividend. In this case:
Pcum = Current Dividend + PV(Future Dividends) = $2 + $4.80/0.12 = 2 + 40 = $42

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 PAYOUT POLICY
Comparison between dividends and share repurchase (3)

1. Pay dividend (2)

After the stock goes ex-dividend, new buyers will not receive the current dividend and the share price will
reflect only the dividends in subsequent years:
Pex = PV(Future Dividends) = $4.80/0.12 = $40
The share price will drop on the ex-dividend data. Amount of drop = Amount of the current dividend $2

Conclusions:
(1) The share price falls when a dividend is paid because the cash reduction decreases the market value of the
firm’s assets.
(2) There is no loss for the shareholders: Before the dividend, the stock was worth $42. After the dividend the
stock is worth $40 and they hold $2 in cash from the dividend. Thus, again a total value of $42.

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 PAYOUT POLICY

Comparison between dividends and share repurchase (4)

Assumptions:
No arbitrage opportunity exists = In a perfect capital market, when a dividend is paid, the share price drops by
the amount of the dividend when the stock begins to trade ex-dividend.
Otherwise, if less drop, one can buy just before ex-dividend and sell after (the dividend will cover more than the
capital loss of the stock)

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 PAYOUT POLICY
Comparison between dividends and share repurchase (5)

2. Share repurchase (No dividend)

Use of the $20 M to repurchase shares in the open market.
How will the repurchase affect the share price?
Initial share price $42. Repurchase $20 M / $42 per share = 0.476 M shares, leaving 10 M –0.476 M = 9.524 M
shares outstanding.
The assets’ market value falls when the company pays out cash, but the number of shares outstanding also falls.
 The two changes offset each other, so the share price remains the same.

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 PAYOUT POLICY
Comparison between dividends and share repurchase (6)

2. Share repurchase (No dividend) (2)

What’s the effect on future dividends?
Expectation of FCF = $48 M, can be used to pay a dividend of $48 M/9.524 M shares = $5.04 per share each
year.
 Thus, with a share repurchase, our share price today is: Prep = $5.04 / 0.12 = $42

That is, by not paying a dividend today, but repurchasing shares instead, we are able to raise our dividends per
share in the future.
The increase in future dividends compensates shareholders for the dividend they give up today.
 In perfect capital markets, an open market share repurchase has no effect on the stock price, and
the stock price is the same as the cum-dividend price if a dividend was paid instead.

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 PAYOUT POLICY
Comparison between dividends and share repurchase (7)

3. High dividend (Equity issue)

The board can decide to pay an even larger dividend than $2 per share now. If so, will it make the shareholders
better off?

Instead of paying $48 M in dividends starting next year, start paying that amount today.
Because the firm has only $20 M in cash today, it needs an additional $28 M to pay the larger dividend now.

What are the options?

(1) Cut down investment, but if it has NPV>0, reducing investment will lower firm value.
(2) Borrow money or sell new shares.

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 PAYOUT POLICY

Comparison between dividends and share repurchase (8)

3. High dividend (Equity issue) (2)

Let’s consider the equity issue:
Given current price $42, the firm could raise $28 M by selling $28 M / $42 per share = 0.67 M shares
The equity issue will increase the total number of shares to 10.67 M.

The amount of dividend per share each year will be:

$48 M / 10.67 M shares = $4.50 per share
Thus, the cum-dividend share price is: Pcum = $4.50 + ($4.50 / 0.12) = 4.50 + 37.50 = $42

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 PAYOUT POLICY

Modigliani & Miller (1961) and Dividend Policy Irrelevance

In perfect capital markets, buying and selling equity and debt are NPV=0 transactions, not affecting firm value.
Thus, the irrelevance of capital structure for firm value.
The same principle applies here too:
The firm can pay a smaller dividend or a larger dividend (by selling equity to raise cash). Because buying and
selling shares is NPV=0 transactions, such transactions have no effect on the initial share price.

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 PAYOUT POLICY

Modigliani & Miller (1961) and Dividend Policy Irrelevance (2)

Conclusions:
(1) In perfect capital markets, holding fixed the investment policy of a firm, the firm’s choice of dividend policy
is irrelevant: It does not affect the initial share price.
(2) By using share repurchases or equity issues a firm can alter its dividend payments. Because these
transactions do not alter the value of the firm, neither does dividend policy.
(3) Our choice of dividend today affects the dividends we can afford to pay in the future in an offsetting fashion.
Thus, while dividends do determine share prices, a firm’s choice of dividend policy does not.
(4) As with capital structure, it is imperfections in capital markets that should determine a firm’s payout policy.

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 PAYOUT POLICY
The Tax Disadvantage of Dividends

Do taxes affect investors’ preferences for dividends vs. share repurchases?

• When a firm pays a dividend, shareholders are taxed according to the dividend tax rate. When a firm
repurchases shares instead, and shareholders sell shares to create a “homemade dividend”, this will be taxed
according to the capital gains tax rate.
• If dividends are taxed more than capital gains, shareholders will prefer share repurchases to dividends.
• But even if the two tax rates are equal, because capital gain taxes are deferred until the asset is sold, there is
still a tax advantage for share repurchases over dividends.
• A higher tax rate on dividends also makes it undesirable for a firm to raise funds to pay a dividend:
o Absent taxes and issuance costs, if a firm raises money by issuing shares and then gives that money back to
shareholders as a dividend, shareholders are no better or worse; they get the money they put in. When
dividends are taxed more than capital gains, shareholders will receive less than their initial investment.

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 PAYOUT POLICY
Optimal Dividend Policy with Taxes

• Firms that use dividends will have to pay a higher pre-tax return to offer their investors the same after-tax
return as firms that use share repurchases.
• As a result, the optimal dividend policy when the dividend tax rate exceeds the capital gain tax rate is to pay
no dividends at all.
 Dividend puzzle = the fact that firms continue to issue dividends despite their tax disadvantage.

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 PAYOUT POLICY

Optimal Dividend Policy with Taxes (2)

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 PAYOUT POLICY

Optimal Dividend Policy with Taxes (3)

While many investors have a preference for share repurchases rather than dividends, the strength of that
preference depends on the difference between the dividend tax rate and the capital gains tax rate that they face:
• Tax rates vary by investor income level (different tax categories/rates), jurisdiction (e.g., foreign investors in
US stocks subjected to 30% withholding for dividends, not the case for capital gains), investment horizon
(more tax on capital gains from stocks held ≤ 1 year, and on dividends from stocks held for < 61 days), type of
investor or investor account (stocks held by individual investors in a retirement account are not subject to
taxes on dividends or capital gains). Thus,
 A firm can optimize its dividend policy for the tax preference of its investors, as
- individuals in the highest tax brackets have a preference for stocks that pay no or low dividends,
- whereas tax-free investors and corporations have a preference for stocks with high dividends.

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 PAYOUT POLICY
Payout vs. retention of cash

If the firm retains the cash:

• In perfect capital markets, once a firm has taken all NPV>0 projects, it is indifferent between saving excess
cash and paying it out.
 M&M61 payout irrelevance: The retention vs. payout decision is irrelevant to total firm value.

• In imperfect capital markets, there is a trade-off: Retaining cash can reduce the costs of raising
capital in the future, but can also increase taxes and agency costs.
 Once a firm has taken all NPV>0 (which increase shareholder value), then it should refrain from
engaging in NPV<0 projects (value-destroying)
 Retain options: Purchase financial assets or hold the cash in the bank (then, pay out to
shareholders at a future time or invest when NPV>0 opportunities occur)

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 PAYOUT POLICY
Payout vs. retention of cash (2)
Example:
Firm to pay corporate tax rate 35% on the interest it will earn from the 1-year Treasury bill paying 6% interest.
Would pension fund investors (who do not pay taxes on their investment income) prefer that the firm use its
excess cash of $100,000 to pay the dividend immediately or retain the cash for one year?
• If the firm pays immediate dividend, shareholders will receive $100,000 now.
• If the firm retains the cash for 1 year, it will earn an after-tax return on the T-bills of 6% * (1 – 0.35) = 3.90%.
Thus, at the end of the year, the dividend to pay will be $100,000 * (1.039) = $103,900.
• This is less than the $106,000 the investors would have received if they have invested in T-bills themselves.
Because the firm must pay taxes on the interest it earns, there is a tax disadvantage to retaining cash.
 Pension fund investors will therefore prefer that the firm pays the dividend now.
 Corporate taxes make it costly for a firm to retain excess cash.

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 PAYOUT POLICY
Payout vs. retention of cash (3)

Example (2):
• Compare with the case of leverage: When a firm pays interest, it receives a tax deduction for that interest,
whereas when a firm receives interest, it owes taxes on the interest.
 Cash is equivalent to negative leverage, i.e., the tax advantage of leverage implies a tax
disadvantage to holding cash.

If there is tax disadvantage to retaining cash, why do some firms accumulate large cash reserves?
• Usually, to cover potential future cash shortfalls. E.g., if future earnings are insufficient to fund future NPV>0
investment opportunities, a firm may start accumulating cash to make up the difference.
 Relevant motivation for firms wanting to fund large-scale R&D projects or large acquisitions
(difference with cases indicative of agency problems)

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 PAYOUT POLICY
Agency costs of retaining cash

• If excess cash: CEOs may use the funds for “pet projects”, excessive perks, or over-paying for acquisitions.
o Décaire & Sosyura (2021): Oil & gas wells drilled in a field near a CEO’s investment properties => 31.8% lower estimated NPV than other
projects of the same firm with similar characteristics. Such projects are realized sooner, receive more capital, are less likely to be dropped.

• The government may take advantage of such “deep pockets” (less help when potentially needed)
• Leverage is one way to reduce a firm’s excess cash and avoid the above costs. Dividends and share repurchases
perform a similar role by taking cash out of the firm.
• For high levered firms: Some of the value of the retained cash will benefit debt holders, and thus equity
holders may prefer to cash out and increase the firm’s payouts. Anticipating this, debt holders will charge a
higher cost of debt or include covenants to restrict the firm’s payout policy.
 Thus, paying out excess cash (through either option) can boost stock price by reducing
wealth/resource transfers to other stakeholders.
 Ultimately, firms should choose to retain cash for the same reasons they would opt for low leverage:
To preserve financial slack for future opportunities and avoid financial distress.
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 PAYOUT POLICY

Asymmetric information: Signaling with payout policy

• When managers have better information than investors, payout decisions may signal this information.
• Usually, firms modify/adjust dividends relatively infrequently, and dividends are much less volatile than
earnings. This practice, i.e., relatively constant dividends = Dividend smoothing

But how firms can keep dividends smooth when their earnings vary?
• In the short term, firms can maintain a dividend level by adjusting the number of shares they repurchase or
issue and the amount of cash they retain.
• But due to the tax and transaction costs of funding a dividend with new equity issues, managers avoid to
commit to a dividend they cannot afford to pay. Hence, in the longer term, they set dividends at a level they
expect to be able to maintain.

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Asymmetric information: Signaling with payout policy (2)

Dividend signaling hypothesis = Dividend changes reflect managers’ views about the firm’s future earnings
prospects. When a firm
• Increases its dividend, sends a positive signal to investors that management expects to afford the higher
dividend for the foreseeable future.
• Cuts the dividend, it may signal giving up hope that earnings will rebound in the near term, hence the need to
reduce dividends to save cash.
• Empirical evidence (Grullon et al., 2002) shows that
o Dividend raise by 10% or more coincided with 1.34% stock price rise after the announcement
o Dividend cut by 10% or more coincided with –3.71% stock price decline after the announcement

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Asymmetric information: Signaling with payout policy (3)

• Dividends may signal optimism, but they could signal also a lack of investment opportunities.
 Hence importance to consider the context (different information and signals)

What about share repurchase signaling?

Some differences with dividends:
1. CEOs are much less committed to share repurchases than to dividend payments. (and they generally
announce the maximum amount they plan to spend on repurchases; the actual amount may be less)
2. Unlike with dividends, firms do not smooth their repurchase activity from year to year
 Repurchases are less of a signal than dividends about future earnings

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 GOVERNANCE MECHANISMS

“Downsize and distribute”: Implications

Necessity for internal and external mechanisms to ensure “good” governance:

• Incentives for managerial alignment to SVM (performance-contingent forms of pay; equity-based

compensation)

• Monitoring (ownership, e.g., concentration and activism; board independence)

• Market for corporate control (external mechanism)

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 INCENTIVES

Compensation

Structure Level

Fixed Variable

Cash bonuses Stock Stock options

Common Restricted

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 INCENTIVES
Incentives = Variable compensation usually depending on some performance criteria; can be short- or long-
term (commonly 3-5 years). Examples: Stock options and restricted stock

Stock options: Call options, giving the right to buy at a certain time at a certain (“strike”) price. The cost of this
right is the “premium”
 Objective: Financial benefit when stock price increases (see alignment of interests)
Problems:
• If exercised, “alignment” is terminated
• Backdating: Choosing another date than the one in which the option has been actually granted (when the
stock price was lower)
o Corrected with the granting of options to be reported to the SEC (U.S.) within 2 days

Penalties related to early exercise, and other restrictions (e.g., performance targets often including market
effects, number of years of employment)

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 INCENTIVES
Justification: Belief in shareholder-manager interest misalignment, i.e., risk-neutrality vs. risk-aversion
• Incentivize against risk-averse behavior (some “risk transfer” to the agent)
• Stock options are valuable when their value remains above the strike price (upside gain without downside
risk): from 19% (1992) to 49% (2000) of exec. pay (Dittmann et al., 2017)

But are managers invariably risk-averse?

• Loss aversion as opposed to risk aversion, risk as a function of “option framing”

Consequences:
• Pay increase: S&P 500 average CEO/average worker = 373/1 in 2014, 344/1 in 2007, 42/1 in 1980 (see
Executive PayWatch)

Is “how much” an issue? What about “how”?

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 INCENTIVES

• Weak linkage to firm performance: It counts for approx. 5% in the variation of CEO total compensation
o On average, each $1,000 change in shareholder wealth corresponds to a 2 cents change in CEO compensation (Jensen
& Murphy, 2010)

• Incentives seem to be rather ineffective

o May further trigger opportunism and even fraud
o May further stimulate risk-aversion: Increasing variable compensation, increasing use of free cash flow to fund
investment projects in industries with imperfectly correlated or even counter-cyclical revenue streams
o Ambiguity as to the role of managerial (CEO) ownership: Although it may tie CEO actions to performance and in theory
align interests, increasing ownership can make a CEO harder to dismiss, thus reducing the effectiveness of the threat of
dismissal.

• Second best solution: Monitoring

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 MONITORING

Ownership monitoring/control processes

1. Shareholders elect the board of directors (usually one slate of candidates, vote yes/no)

2. Shareholder voice (through vote and activism):

• Any shareholder can submit a resolution that is put to a vote at the annual meeting. A resolution could direct
the board to take a specific action, e.g., discontinue investment in a particular line of business or country, or
remove a poison pill.
• Activist shareholders address directly to the CEO and board. If they fail to comply, they can put the issue to a
shareholder vote.
o Activism has been successful in removing poison pills and other defenses designed to entrench management (see also
“no” campaigns = convince the majority of shareholders to withhold their approval of the reelection of the CEO)

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 MONITORING

Ownership monitoring/control processes (2)

3. Shareholder approval: Approve major actions taken by the board.

• E.g., target shareholders must approve merger agreements, sometimes bidder shareholders too
• Say-on-pay voting, although in many cases this is a non-binding vote

4. Proxy contests: Perhaps the most extreme form of direct action, introducing a rival slate of directors for
election.
• An actual choice between the nominees put forth by the CEO and board vs new ones from dissident
shareholders

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 MONITORING
Ownership concentration and type

Institutional investors
• Pressure-sensitive owners
o Banks and insurance companies

• Pressure-resistant owners: Seen as having monitoring motivation and expertise at low cost (access to non-
publicly available information)
o Mutual funds
o Hedge funds
o Pension funds

Differences among types of institutional investors in terms of behavior (e.g., motivation to monitor)

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 MONITORING
Ownership concentration and type (2)

• Transient investors: Trade rather than invest

o Probable indifference in exercising thorough monitoring in one firm

• Passive investors: Diversify their portfolio across firms/industries/countries – see also “index tracking”
o Effective in increasing independent directors, removing poison pills
o 10% passive ownership increase  4% decline in support for management proposals, reduced cash holdings, higher
dividends, decline in managerial pay, higher operational performance (ROA)

• Re-concentration of ownership due to increasing parts acquired by “index trackers”. E.g., BlackRock,
Vanguard, State Street (Big Three): Largest shareholder in 40% of all US-based firms and 88% of S&P500
o Influence management through “private engagements”. E.g., in one year (mid 2014 – mid 2015), BlackRock has
performed over 1,500 with firms held in its portfolio: 670 in Americas and about 850 in the rest of the world (Fichtner
et al., 2017)

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 MONITORING
Ownership concentration and type (3)

Family owners
• Socio-emotional wealth preservation (SEW): Maintain control and satisfy needs for belonging, affect, as well
as perpetuate family values through the business
 To avoid SEW loss, family owners are willing to accept a significant risk to their performance; yet
at the same time, they avoid risky business decisions that might aggravate that risk.

State owners / Sovereign Wealth Funds (SWF)

• SWFs are state-owned investment funds, typically pursuing long-term investment strategies internationally
• Central banks play a role in funding (sources include trade surpluses and revenues from natural resources)
• States as owners have also non-financial objectives, blurring the lines between finance and politics: E.g.,
geopolitical positioning, national employment, home country future generations’ well-being.

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MONITORING

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 MONITORING
Board independence

• The board selects, evaluates, and compensates the CEO, as well as contributes to/approves major decisions
(strategy, capital structure, financial statements, compliance with law/regulations)

Board Directors

Outsiders Insiders

Affiliated Independent

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 MONITORING
Board independence (2)

• Example: NYSE rules. Publicly listed firms must have a majority of independent directors, i.e., with no
“material” (contractual, family) relationship with the firm
• In the preceding 3 years, s/he or an immediate family member,
o Employed in the firm (family member as executive)
o Earned direct compensation > $100,000 per year from the firm
o Employed by current or former, internal or external, auditor of the firm
o Employed as executive at another firm where any of the firm’s current executives was on that firm’s compensation
committee
o Employed as executive of another firm that makes to or receives payments from the firm > $1 M or 2% of its gross
revenue in a year

• Outside board directors must regularly hold meetings without inside board directors (i.e., who concurrently
serve as managers in the same firm)

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Board independence (3)

• Duality regime, when the CEO concurrently holds the position of chair of the board
o Seen as the CEO grading her/his own homework
o Despite unambiguous leadership/responsibility (unity of command), blamed for “suboptimal” awareness and slow
strategic response

• Sarbanes-Oxley Act (SOX, 2002): Primary purpose to protect investors from managerial misconduct (e.g.,
accounting fraud). Independent directors, assumed to be able to exercise independent judgment over the
firm’s CEO
o Similar concerns in other countries (e.g., BE, D, ES, FR, JP, NL)

• Lead independent director

o A compromise that diffused after SOX 2002
o Reflects board/CEO power balance and prevents Chair/CEO split

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Other stakeholders that can act as monitors

• Securities analysts
They produce independent valuations of the firms they cover so that they can make buy and sell
recommendations to clients. They collect information, becoming experts of a firm and its competitors. They
tend to be inquisitive in talks with CEOs and CFOs.
 Side-effects of their industry expertise (see, e.g., Zuckerman 2000, on the consequences in
evaluating business-diversified firms)

• Lenders and employees

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Regulation

• Example: 2002 Sarbanes Oxley Act  Improve the accuracy of the information given to boards and
shareholders.
(1) Overhauling incentives and independence in the auditing process: Given auditors’ typically long-term and
multifaceted (e.g., consulting) relations with their clients, more difficult to challenge them. SOX puts strict
limits on the amount of non-audit fees; requires audit partners to rotate every 5 years; requires audit
committees with mostly outside directors, and at least one with financial background.
(2) Stiffening penalties for providing false information: CEOs and CFOs have to personally attest to the
accuracy of financial statements and to sign a statement in that effect. Penalties went up to $5 M fine and 20
years imprisonment. They must also return profits or bonuses from stock sale or option exercise during a
period during which there has been a financial restatement.
(3) Firms have to validate their internal financial control processes: See Section 404, requiring CEOs and
boards to be knowledgeable on fund allocation processes.  Potentially enormous burden to having to validate
the entire firm financial control system. Greater burden for smaller companies.

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Regulation (2)

• Example (2): 2010 Dodd-Frank Act  resulting from the 2008 crisis, aimed to further strengthen
governance:
o Independent compensation committee
o Shareholders owning at least 3% for at least 3 years may nominate candidates for the board alongside management’s
nominees
o At least every 3 years, non-binding vote (but explain how the vote has been accounted for) on the compensation of
CEO, CFO and top 3 other managers
o Allow firms to take back for up to 3 years any incentive scheme erroneously awarded as a result of a restatement
o Pay disclosure of the ratio of annual CEO compensation to the median employee

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