Lecture Agency Tunneling Ownership FULL ForRepro Apr19 2024

Agency Conflicts and Corporate Governance
Prof. Florencio Lopez de Silanes

SKEMA Business School and U.S. NBER 1
Road Map
 Introduction.
Taxonomy of Agency Conflicts and Tunneling.
Evidence of Agency Costs.
Solutions to the Agency Problem.
2
Role of The Financial Manager
in Classic Finance
(2) (1)
Insiders
Firm's (managers / Financial
operations controlling (4a) markets
shareholders)
(3) (4b)
(1) Cash raised from investors

(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested /Capital budgeting
3 (4b) Cash returned to investors
M&M Perfect World - Classic Finance
STOCKHOLDERS
Hire & fire managers Maximize

- Board stockholder wealth
- Annual Meeting
Lend Money No Social Costs
BONDHOLDERS Insiders SOCIETY

(Managers/Controlling Shareholders)
Protect Costs can be
Bondholder interests traced to firm
Reveal information Markets are efficient and

honestly and on time assess effect on value
FINANCIAL MARKETS
4 In traditional Miller & Modigliani world, the objective in decision making is to maximize

the value of the firm.
Why Stock Price Maximization Works?
Stockholders hire managers to run their firms for them

Because stockholders have absolute power to hire and fire managers.
Managers set aside their interests and maximize stock prices
Because markets are efficient.
Stockholder wealth is maximized
Because lenders are fully protected from stockholder actions.
Firm Value is maximized
Because there are no costs created for society.
Societal wealth is maximized.
 In the Perfect M&M world, the objective in decision making is to

maximize the value of the firm.
Example
 Wirecard AG is a German payment processor and financial services provider which is listed on the German
stock exchange. The company offers its customers electronic payment transaction services and risk
management, as well as the issuing and processing of physical and virtual cards. It offers the platform of
many other firms to offer full banking services across Europe. Clients include many FinTech names of note
including Revolut, Curve, Funding Circle and Pockit.
 “….one of the highest valued financial firms in Europe and Germany.”
 https://www.youtube.com/watch?v=ivACzzW5wyA
Example
 On June 18th 2020, Wirecard said auditor EY couldn’t find the cash balances, which
represent roughly a quarter of its balance sheet. $2.1 b supposedly deposited in Philippino
Banks. The banks denied knowing Wirecard.
 Stock plummets over 85%
 https://www.youtube.com/watch?v=NDEzsQjFpik
Example
 The Financial Times had been conducting an investigation for over 2 years, …. Yet experts,
authorities and rating agencies did not believe it.
 https://www.ft.com/content/284fb1ad-ddc0-45df-a075-
8
0709b36868db?segmentId=98cc4897-a740-285b-6541-6459c8ed665f
Example
1. Example 2. Course administration 3. Course overview
 June 18th Wirecard’s auditor for 10 years (EY) said that it could not find $2.1bn, amounting to nearly ¼ of the firm’s
balance-sheet. Wirecard then withdrew its results for the last fiscal year and for Q1 2020.
 June 19th Philippines denies having Wirecard’s money. CEO Markus Braun resigned.
 June 22nd Wirecard admitted that the €1.9bn “probably does not exist”. Braun was arrested (fraudulent accounting
techniques to inflate reported revenues).
 June 25th Wirecard began insolvency proceedings. 9
 July 2 nd Wirecard administrator starts to dismantle it. Shares have plunged by about 98%, wiping out more than €12bn
Example
 Wirecard had ticked the box in Corporate Governance legal requirements (i.e. its Boards of
Directors requirements, etc..).
 It is subject to strict German regulation, including a two-tier board with a Supervisory
Board, that includes independent directors and members of the labor unions, and a
separate Management
 It has also grown to be one of the top German stocks included in German indices and,
therefore, closely regarded and monitored by Rating Agencies, Financial Analysts,
Institutional Investors, and Financial Markets’ Regulators.
 Question. What were Board Members doing?

10 What were their duties?
How were they carrying them out? Could they have prevented the fraud?
STOCKHOLDERS
Hire & fire managers Maximize

- Board stockholder wealth
- Annual Meeting
Lend Money No Social Costs
BONDHOLDERS Insiders SOCIETY

(Managers/Controlling Shareholders)
Protect Costs can be
Bondholder interests traced to firm
Reveal information Markets are efficient and

honestly and on time assess effect on value
FINANCIAL MARKETS
11 In traditional Miller & Modigliani world, the objective in decision making is to maximize

the value of the firm.
Incomplete Contracts and Moral Hazard.
 Nature of Moral Hazard problems:

Parties to a financial agreement make relationship-specific investments that are sunk.
 Sunk (irreversible) investments and sharing arrangements give rise to incentive conflicts
when contracts are incomplete and when parties cannot monitor performance perfectly.
 What are relationship-specific investments?

 Investment is specific if it has more value in the relationship than in alternative uses
 Once a relationship-specific investment is made, a party can try to behave opportunistically
and renegotiate the terms of the contract and appropriate rents.
 The potential for expropriation depends on the specificity of the investment.
How concerns about opportunism affect contractual relationships?

 Parties to a relationship try to avoid making relationship-specific investments.
 This is inefficient Contract provisions reflect efforts to align incentives and limit
12 opportunism.
Incomplete Contracts and Moral Hazard
 Examples.
 Insurance markets: where the presence of insurance
causes people to take more risk that they would otherwise
have taken.
 “No curb is too high for my rental car.”
 Once you pay a worker a fixed salary, she has an incentive
to “shirk” and not perform at full effort
 Some faculty members!.
 Once a bank has loaned $ to a nearly-bankrupt company
for a positive NPV project, the firm has an incentive to take
a more risky, and possibly negative NPV project (“bait-and-
switch”).
 More generally, once the investor has given money to the
firm, managers may divert the money towards “private
benefits” (e.g., ranging from nice corporate headquarters
13
and empire building to outright theft).
The Impact of Agency Problems
 M&M  securities are akin to the slices of a pizza  they carve out cash flows:
 Debt receives coupon and principal.
 Equity gets dividends.
 No role for control/power/authority.
 Something is missing.
 Agency Hypothesis
 Shareholders may not be best qualified to run the firm  require specialized
knowledge  shareholders (“principals”) hire a CEO (“agent”).
 CEO may not have sufficient financial resources to own the firm / may want a
diversified portfolio.
 The separation of ownership and control is beneficial.
14
The Impact of Agency Problems
 Grossman & Hart:

 Shareholders do not have full control over the CEO because they cannot write a
complete contract (too many contingencies).
 The CEO has some control rights (i.e, has discretion)
  can pursue goals other than maximizing shareholders wealth.
 The separation of ownership and control is beneficial but costly.
 Next, we consider different examples of agency problems.
15
Road Map
Introduction
Taxonomy of Agency Conflicts and Tunneling.
16
Agency Conflicts / Tunneling
 The term “tunneling” was first used to characterize the expropriation of minority
shareholders in Czech Republic—as in removing assets through an underground tunnel—
to describe the transfer of assets and profits out of firms for the benefit of those who
control them.
 Reported incidents of tunneling are not restricted to the Czech Republic and did not start
after the “US Corporate Governance Crisis.” Some examples include:
 “Argentine Small Holders Get No Respect”—WSJ

 “Behind Enron’s Fall…Hidden Deals with Officers and Minimal Disclosure Finally
Cost is its Trust ”— WSJ
 “Spain’s Telefónica Jolts Latin America With Tough Tactics”—WSJ
 “Telecom Italia Scuttles Split-Off Of Wireless Unit” —WSJ
 “Hot shares, bothered investors [in Russia]”—The Economist
 “Chaebol fined for subsidizing weak units”—FT
17
The Flavors of Agency Conflicts
 Agency Conflicts comes in two forms:
1. An insider (controlling shareholder or manager) can simply transfer resources from the
firm to his own benefit through self-dealing transactions:
a. Taking corporate property:
 Perks (e.g., airplanes, plush offices, etc).
 Insider Trading.
 Corporate Opportunities.
b. Self-dealing:
 Asset sales.
 Transfer pricing / Corporate loans.
c. Asset stripping
d. Excessive executive compensation.
e. Actions with mixed motives (e.g., implement harmful anti-takeover strategy).
2. An insider can increase his share of the firm without transferring any assets.
a. Going private
18 b. Dilutive share issues.
Road Map
The Flavors of Agency Conflicts:
1. Transfer corporate resources to the insider.

a. Taking corporate property
b. Self Dealing
c. Asset Stripping
d. Executive Compensation
e. Mixed Motives
2. Diluting outsiders’ share in the firm.
19
Taking Property
Plane
20
Source: Clark, Corporate Law
Taking Property (2)
 Public Corp is worth $100 Billion.
 Buying a Lear jet costs $120 M and offers cost savings (in executive time plus airfares)
worth $20 M in present value.
 The CEO owns $10 M in stock.
 Buying Lear jets destroys $________ M in firm value.

 The stock price drops ______%. So, as a result, the CEO suffers a loss of $ _______.
 Cost of the plane to shareholders: $___________
 Cost of the plane to Insider: $___________
21
Road Map

b. Self Dealing
c. Asset Stripping
e. Mixed Motives
22
Self-Dealing
 The insider in the diagram owns 25% of Public Corp and 100% of Private Corp.
 In a deal among the two companies, the risk is that Public Corporation will get
cheated because the insider has a greater vested interest in ensuring the welfare of
Private Corp than in Public Corp.
 For example, Public Corp may acquire assets/services from Private Corp at
23
inflated prices.
24
WeWork’s
Self-Dealing
WeWork’s
Self-Dealing
WeWork's co-founder and former CEO, Adam
Neumann, held a vast influence over the
company, with majority voting power.
He took advantage of the power by self-dealing
transactions:
Created the We trademark and then sold it to
the company for $6m, raising further concerns
regarding sound corporate governance.
Bought properties and leased them to his

firm, with the firm paying for the renovation
costs
Self-Dealing:
On the Mechanics of Enronism
1. You have two cows
2. You sell three of them to your publicly listed company, using letters of credit opened by
your brother-in-law at the bank
3. Then execute a debt-equity swap with an associated general offer so that you get all
four cows back, with a tax exemption for five cows
4. The milk rights of the six cows are transferred through an intermediary to a Cayman
Island company secretly owned by the majority shareholder
5. The majority shareholder sells the rights to all seven cows back to your listed company.
6. The Enron annual report says the company owns eight cows…
7. …with an option on one more.
From: Politicalhumor.about.com
27
Road Map

b. Self Dealing
c. Asset Stripping
e. Mixed Motives
28
Czech Republic: TV Nova
(Asset Stripping)
100%
Central European
Vladimir Zelezny
Media Enterprises CME
(Controlling Shareholder)
(Controlling Shareholders)
Rival Operation
(TV Nova’s Competition)
60%
CET 21
License Holding Company
(TV Nova’s License)
Transfer of TV Nova’s signal to rival operation
TV Nova
(CEO Vladimir Zelezny)
29
Czech Republic: TV Nova
(Asset Stripping) (3)
 CME’s shares, which are listed on Nasdaq, fell by around a third.
30
Spain & LA: Telefónica S.A.
(Asset Stripping)
Telefónica S.A.
(Spanish Parent Company)
100%
Telefónica International
(Holding Company)
53%* 100% 52% 44% 35%
Terra Networks
Telefónica de Argentina Telesp Participacoes Telefónica de Chile Telefónica del Peru
(Wholly-owned
(Argentinean subsidiary) (Brazilian subsidiary) (Chilean subsidiary) (Peruvian subsidiary)
internet subsidiary)
100% 100%
Advance Diversion of a corporate opportunity CTC Mundo 100%
(Wholly-owned through the acquisition of ZAZ (Wholly owned subsidiary)
internet subsidiary)
Shareholder-blocked sale 100%
of Advance Telefónica Servicios
Telefónica.Net
de Internet
(Internet subsidiary)
(Internet subsidiary)
Sale of Telefónica.Net for $48 million ($40m cash; $8m debt)
Sale of TSI for $30 million in cash

*Telefónica Spain owned 53% of Telefónica de Argentina. However Telefónica Spain didn't have the control of its subsidiary. Telefónica
Spain
31 transmitted some of its voting rights over Telefónica de Argentina to its former partner, CEI Citicorp, controlled by HMT&F.
This transfer gave HMT&F control over Telefónica de Argentina (Despite it didn’t have the majority of shares). That’s the reason why
HMT&F and other minority shareholders could block the sale of Advance.
Spain and Latin America: Telefónica
S.A.
 In 1998, Telefónica S.A. created Terra
Networks (TN), an internet service
provider. Since its creation, TN has
enjoyed of Telefónica’s resources to take-
off.
 In August 1999, Telefónica de Chile

approved the sale of its internet branch,
Telefónica.Net, to TN for a total of $40
million plus $8 million in debt.
 Analysts valuated Telefónica.Net around

$200-$250 million.
 Stock prices plummeted in the

Argentinean, Brazilian, Chilean and
Peruvian subsidiaries of Telefónica Spain.
32
Spain and Latin America: Telefónica
S.A.
 On November 17, 1999 Terra Networks went

public in both the Spanish Stock Exchange
and NASDAQ.
 In the U.S., TN’s IPO was priced at US$13.41

per ADS and concluded the day trading at
US$38.25. (WSJ 11/18/99).
 After the IPO, Spain’s Telefónica retained

control of Terra Networks holding more than
77% of its ordinary shares.
33
Spain and Latin America:
Adios Don Juan.
 Juan Villalonga was the CEO of Telefónica
when the transaction took place.
 He had close ties to the socialist government of

Aznar (in fact, he was the godfather of one of
Aznar’s daughters).
 The rapid rise in the compensation of

Telefónica was a major source of
embarrassment for the socialist government.
 He was forced to step down in 6/2000 over

allegations he used privileged knowledge to
buy Telefónica shares in 1998 making a profit
of $119,000.
34
Road Map

b. Self Dealing
c. Asset Stripping
e. Mixed Motives
35
Tunneling (Executive Compensation)
 The Public Corp pays Insider for her role as CEO.

 There is a risk that compensation may be excessive due to Insider’s influence on
Public’s decisions.
36  Insider’s power over corporate decisions exist because of the weak influence of
the Board of Directors in the setting of Executive Compensation.
Japan/France:
Renault-Nissan-Mitsubishi
 Mr Ghosn was arrested in Tokyo getting off his plane on 21/11/18. He is accused of:
 Under-reporting his pay to regulators by around ¥5bn ($51m) over 5 years.
 Broking the law by failing to declare his use of properties owned by Nissan in several
cities, including Beirut, as a perk.
 He had indeed accumulated huge power in his multiple roles, and used it to build a group
that had become the world’s biggest carmaker (11m vehicles this year). Questions will be
asked about Nissan’s governance, and about the oversight provided by its board.
 Another interpretation is that activities which were known about and once attracted a blind
eye have now been used against Mr Ghosn to get him off Nissan and recover it for Japan.
 In Japan lower pay is often compensated with plenty fringe benefits customarily unreported.
37
Japan/France:
Updated Aug. 6, 2022
Renault-Nissan-Mitsubishi
38
https://www.wsj.com/articles/carlos-ghosn-escape-japan-private-jet-box-hidden-11659733392
Germany: Deutsche Bank
(Excessive Executive Compensation)
 The management of Deutsche Bank proposed to be granted a stock option plan which
would enrich senior management by an amount of approximately 100 million euros, if the
performance of the stock over the next ten years just equaled the return on German
government bonds.
 With the support of proxy votes cast by the united German banking community, the plan
got the consent of 99% of the shares present in the stockholder meeting
39
Video
40
Executive Compensation
 The average American CEO takes home 399 times the wage of a factory worker. More
than the previous peak in 2000. In 1965, that figure was 20. Is it too much?
 Note: We can’t make it illegal to compensate CEOs.
41
Note: We can’t make it illegal to compensate CEOs.

Road Map
Tunneling comes in two flavors:

b. Self Dealing
c. Asset Stripping
e. Mixed Motives
42
Actions with Mixed Motives.
 The Insider influences Public Corp to pay $50 M to buy the 20% of Public Corp
recently acquired by Raider (“greenmail”). Raider had recently announced plans to
gain control of Public Corp and change its business strategy.
 Danger: Public Corp may be paying an unfairly high price to preserve private
benefits enjoyed by Insider (but not be minority shareholders).
43
 Key problem: We can’t make bad investment decisions illegal.
Actions with Mixed Motives (2)
 Examples of actions with mixed motives.

 Invest in projects to get entrenched.
 Rely on implicit contracts and personal relationships to make replacement
difficult.
 Similarly, make investments that are difficult for somebody else to manage.
 Survival of the company with themselves at the helm.

 Managers make firm-specific investments (eg, knowledge about firm’s business)
which are worthless if the firm goes out-of-business
 Excessively conservative investment policy (they care about idiosyncratic risk).
For example: Excessive diversification.
 Too little debt.
44  Empire building.  Size   CEO’s prestige, power and compensation.

Road Map

a. Going Private
b. Dilution
45
Going Private
 A good example of going-

private transactions is
Velcro Industries, the
producer of the famous
“touch fastener”
incorporated on the island
of Curacao in the
Netherlands Antilles.
 Two-thirds of the shares of

Velcro Industries are
controlled by the Cripps
family that runs Velcro.
46
Going Private (2)
 Despite a large cash reserve, the company suspended dividends, delisted itself from the
Montreal Stock Exchange, and aggressively wrote down assets to slash earnings,
evidently to “buy out Velcro minority holders cheap”.
 The share price dived and, tow years later, with dividends remaining at zero, the Cripps
offered to repurchase minority shares at slightly above the market price.
 Minority shareholders sued in New York and a judge ruled that the U.S. was the proper
jurisdiction. The Cripps then decided to call off his offer rather that go under the light of
47
U.S. court of law. The company subsequently resumed its dividend payments.
Road Map

a. Going Private
b. Dilution
48
Tunneling. Dilution.
 Russia’s tycoon: Mr. Khodorkovsky, CEO and controlling shareholder.
49
Yukos before Dilutive Operation.
Mikhail Khodorkovsky
(Menatep)
CEO and controlling
shareholder
Menatep 78%
OFF-SHORES YUKOS E&P MINORITY
Set up by Khodorkovsky (Holding Company) SHAREHOLDERS
Y 51% M 37% Y 51% M 37% Y 51% M 37%

Tomskneft Samaraneftegaz Yuganskneftegaz
(Subsidiary) (Subsidiary) (Subsidiary)
 Yuganskneftegaz supplies 61% of consolidated YUKOS oil output;


50 Samaraneftegaz supplies 17% of consolidated YUKOS oil output;
 Tomskneft supplies 22% of consolidated YUKOS oil output.
Yukos: The Show Goes on
 First Act:
 A bailiff opened Tomskneft EGM by locking out minority shareholders, claiming that the
register had not kept proper record of them.
 Behind closed doors, Tomskneft agreed to increase the number of shares by 300%
and place these new shares with five offshore companies (which critics suspect are
secretly controlled by Khodorkovsky (Menatep)).
 The offshore companies paid the equivalent of $40 mln with the subsidiary’s own debt
valued at close to par value, although it was trading at a big discount in the secondary
market.
 Tomskneft agreed to sell oil to YUKOS E&P at RUR 250 per ton for the next three
years while the market price was roughly nine times larger. The agreement to sell oil
was made retroactive for a period of three years.
 SecondAct:
 Similar transactions take place at the EGMs of the other two YUKOS’ subsidiaries.
51
Grand Finale:
Yukos after Dilutive Operation.
Mikhail Khodorkovsky
CEO and controlling
shareholder
OFF-SHORES YUKOS MINORITY

Set up by Khodorkovsky (Holding Company) SHAREHOLDERS
Y 10% M: 37 9% Y 15% M: 3713% Y 17% M: 3715%

Tomskneft Samaraneftegaz Yuganskneftegaz
(Subsidiary) (Subsidiary) (Subsidiary)
OS 80% OS 70% OS 66%
The Share Issues to off-shore companies controlled by Khodorkovsky

52 Because of Rounding, figures do not add up to 100.
Sources: Materials from board meetings of Yuganskneftegaz, Samaraneftegaz and Tomskneft.
Yukos: The Show Goes on
 Third Act:
 Tomskneft’s EGM was due to take place in Moscow.
 Minority shareholders arrived to discovered a note on the wall, saying the meeting would
take place at Mosalsk (a 2-3 hour drive).
 Fourth Act:
 YUKOS released the ratios at which it proposed to swap its shares for those of its three
subsidiaries. YUKOS valued its shares at R6 ($0.25)
 Inexplicably, an independent appraisal commissioned by minority shareholders produced very
different valuations
Valuations
YUKOS Independent Appraisal
YFGA $1.75 $11.25
SMNG $1 $10
TOMG $0.75 $8.5 53
Recap. How to Steal a Company
1. Lock minority shareholders out using Byzantine methods:

 Fail to register minority investors.
 “Convince” judges that minorities are not allowed in the meeting.
 Organize shareholders’ meetings in places that cannot be reached.
2. Issue more stock in the company’s subsidiaries.

 Dilute all shareholders.
 Place new shares in your offshore companies & argue they are not linked to you.
3. How to pay for the newly issued shares in the company’s subsidiaries?
 Easy, with the subsidiaries’ own debt!!!!!
4. Keep the oil of the subsidiaries:

 Sell cheap oil to the holding and pocket the $—in your offshores.
 In a locked shareholders’ meeting, enter a 3 yr sale agreement at steep discounts.
 Better Still, make this contract retroactive for some years.
54
Conclusions.
 Tunneling is the central moral-hazard and agency problem in many countries.
 Tunneling takes many forms, including: expropriation of corporate opportunities

from a firm by its insiders, transfer pricing, etc.
 In developing countries, minority shareholders have difficulty obtaining redress

because courts don’t work.
 However, sometimes tunneling is legal even in developed countries. Tunneling may

be perfectly legal if insiders take care to structure transactions so that they have a
plausible business purpose.
 In all countries, courts have a difficult time restraining perks, actions with mixed
motives, and examining strategic decisions (e.g., mergers).
55
Road Map
Introduction.
Taxonomy of Agency Conflicts.
 Evidence of Agency Costs:

Anecdotal evidence;
Evidence on investment announcements;
Evidence on takeover resistance;
Evidence on block and voting premia.
56
Evidence on Agency Costs
The upshot is that mangers end up with significant control rights (discretion) over
how to allocate investor’s funds.
A considerable amount of evidence has documented the prevalence of managerial

behavior that does NOT serve the interest of investors.
Most of the evidence is “event studies”:

Idea: If stock market falls when managers announce an action, then the action
must serve the interest of managers and not of shareholders
(You obviously need actions that do not convey other bad information)
57
Evidence from Investment Announcement
Negative returns for oil companies
 Oil producers spent roughly $20 per barrel to explore in the mid-1980s rather than return
cash to shareholders or buy proven oil reserves that sold in the marketplace for $6 per
barrel (Jensen; McConnel and Muscarella).
 Although growth can be NPV<0, they keep investing because:

 They get more often in the “gossip column” of the press.
 They have all their human capital tied to the firm, so you do not want to lose it.
 Nobody likes to run a shrinking business, since you do not get invited to cocktails.
 Example: Negative returns for oil companies announcing expansions:

 Funny because you do NOT need to report these acquisitions, so you expect reporting
of good ones so that p.
 But here, the announcement of new explorations caused p since: (1) it cost $18 a
barrel to explore for new oil resources; and (2) the cost of a proven reserve of a barrel
of oil in the market was $6 (so, just to get it out).
59
Evidence from Takeover Resistance
Negative Returns When Managers Resist
 Inept managers expropriate from investors when they entrench themselves and stay on the
job and resist being kicked out.
 In the US, managers resisted takeovers to keep their jobs.
 The wealth consequences to shareholders to defeat a takeover is to  P a lot.
 Managers always find excuses for doing this:

 “He was just bargaining for a higher price, but then he left.”
 “Bidders were underpaying for our company.”
 “The market price is too low, but it is really worth more.”
 Managerial resistance to value-increasing takeovers is less when managers have share

ownership and golden parachutes, or when they will keep their jobs.
60
Evidence on the Death of Founders
 The sudden death—in plane crashes or from heart attacks—of founders is good news for shareholders perhaps
because benefits of control diminish after the death of powerful managers (Johnson et al.)
61
The Death of Founders
 Armand Hammer…When he died,  P 20%.
 “… when a rumor of the death of the 81-year-old Mr. Agnelli

swept Italian markets, Fiat's ailing stock leapt by 6 percent.
Some investors hoped that the departure of a man whom Italians
call "l'Avvocato" — the lawyer — would hasten the sale of the
chronically money-losing auto division that has powered the
62 intertwined destinies of Fiat and the Agnelli family since the
company was founded in 1899.” (NYT)
The Death of Entrenched CEOs
 Salas (2010):
63
The Death of Entrenched CEOs
 Salas (2010):
64
Evidence on Block Premia
 Control has a price

which is inconsistent
with the view that the
benefits received by
controlling
shareholders are
proportional to their
ownership.
 In the US, large

blocks of shares trade
at a premium to the
post-trade price of
minority shares
(Barclay and
Holderness).
65
Evidence on Voting Premia
66
Road Map
 Introduction.
 Taxonomy of Agency Conflicts.
 Evidence of Agency Costs.
 Solutions to the Agency Problem.
67
Agency Conflict and the Costs for Raising
Capital - Example.
 If an entrepreneur devotes all of her effort to a venture, it will be worth $1 million.
 Now imagine that the entrepreneur sells a 40% stake in the firm to an outside investor. The
entrepreneur is a workaholic but, unfortunately, the investor does not know that she is.
 Instead, the investor believes she would reduce effort to the point where the venture is only
worth $600,000.
 How might the parties use monitoring and bonding arrangements to change the deal? Any
mechanisms you can think of using?
 How much money would the Entrepreneur be willing to spend monitoring the entrepreneur?
68
Road Map
Introduction.
Taxonomy of Agency Conflicts.

Simple Model of Tunneling
69
A Simple Model of Tunneling (1).
 In countries with low investor protection, insiders can use their control over corporate
decisions to divert resources of the firm for their own benefit (hurting outside investors).
 Agency Theory around the World.
 However, insiders will typically worry about getting caught (unless the country is completely
lawless).
 Insiders will waste resources disguising transactions to create the impression that
outside investors are being treated fairly.
 Example: The insider may buy useless widgets from his cousin at above-market
prices to get cash out of the firm.
 Tunneling is inefficient. Outside investors will put a lower value on the assets of the
firm and insiders will bear the cost. As a result, insiders would like to find a way to
commit to abstain from tunneling.
70
Setup of the Model.
 The firm is controlled by a single shareholder who owns a fraction  of the equity.
 The firm has $I in cash.
 It can invest $I in a project that returns the gross rate of return R.

 The firm has no costs. Thus profits are given by R*I.
 The world lasts two periods.
 The entrepreneur can divert a fraction s of the profits from the firm to himself before he
distributes the rest as dividends (e.g., excessive compensation, transfer pricing, etc).
 However, unless the entrepreneur can steal with impunity, she has to engage in costly
maneuvering c to divert profits (e.g., risking possible legal challenges).
71
 Two things happen as insiders increase tunneling by Δs:
1. Insiders’ dividend income falls by $*Δs*Profits as cash is siphoned off.
2. Insiders gets added private benefits of [Δs -Δc(k,s)]*Profits.
 For each $1 of profits, the benefit from Δs is:
(1- )* Δs - Δc(k,s)
 Insiders will adjust Δs until:

[(1- )* Δs] - Δc(k,s) = 0
 Solving the former equation we have that, in equilibrium:
73 (1- ) = Δc(k,s)/ Δs
c(k,s) The slope of c(k,s),

c(k,s) (Δc/Δs) measures the
increase in wasted $
as insiders step up
expropriation.
In equilibrium,
insiders will adjust
s until: (Δc/Δs) =1-
0 s* 1 s
s represents the fraction of The curve describes the relationship

the profits that the between tunneling s and the costs of
74 entrepreneur diverts. tunneling c. As s increases, it is costlier to
tunnel.
c(k,s) c(k’,s) where k’>k

c(k,s)
(Δc/Δs) =1-’
where ’ > 
0 s*’ s* 1 s
 Tunneling is low when:
1.  is high. The insiders bears a large fraction of the costs of cutting
dividends.
75 2. Legal protection is strong (k ↑): Tunneling is less effective in such
countries (insiders need to sacrifice too much dividend income to loot).
Implications of the model.

 Tunneling is low when:
 Legal protection is strong. Intuitively, chances of getting caught are higher in
countries where investor protection is high  tunneling is less efficient in such
countries (insiders need to sacrifice too much dividend income to loot).
  is high. The insiders bears a large fraction of the costs of cutting dividends.
 Tunneling decreases the willingness of financiers to pay for assets inside the firm.
 Tobin’s Q = PV(profits)/Value of assets = (1-s)*R*I/I

 Tobin’s Q = (1-s)*R  valuation is low when looting (s) is high.
 Valuation levels improve with k and .
 Tunneling is inefficient. The entrepreneur would prefer to find a way to avoid it. This is a
common problem in moral hazard (last lecture): if entrepreneurs could costlessly commit
76not to steal, they would.
Prof. Florencio Lopez de Silanes 77

Road Map
 Introduction.
 Taxonomy of Agency Conflicts.
 Evidence of Agency Costs.
 Solutions to the Agency Problem.
78
Why aren’t Agency Problems easily solved?
 Why do shareholders do NOT bribe the CEO to leave if he is performs poorly according
to their interest?
 Why is the Coasian renegotiation not feasible?
79
Solutions to the Agency Problem
Managerial discretion, reduces the amount of resources that investors are willing to
put ex-ante to finance the firm (Williamson, Grossman-Hart).
Corporate Governance deals with the constraints that insiders put on themselves,
or that investors put on insiders, to mitigate agency problems and, thus, induce
investors to provide more funds ex-ante.
If there is $ left on the table, there should be mechanisms to try to mitigate
agency costs.
80
 Mechanisms of corporate control:

o The Law
o Debt
o Dividends
o Boards
o Managerial Ownership
o Incentive Contracts
o Labor Market
o Banks
o Large Shareholders
 Jawboning
 Proxy Fights
 Takeovers
81
How is Expropriation Restricted?
Legal Approach to Corporate Governance
 The law and its enforcement are key mechanisms of investor protection.
 When investors finance firms, they receive rights or powers in exchange.
Without an ability to enforce rights, investors might end up with nothing.
•Company law
•Bankruptcy law •Protect Shareholders &
•Securities law Creditors
•Takeover law
•Force timely disclosure of
•Courts &
accurate information
Regulators
 Implication: Strong investor protection leads to deeper financial

82 markets & better financing terms for firms.
Legal Origins
= English
= French
= German
= Scandinavian
= Socialist
83
The distribution of Legal Origin
Measures of Investor Protection
Shareholder Creditor Efficiency of Accounting

Rights Rights the Judiciary Standards
(0-6) (0-4) (0-10) (0-100)
Common Law 4.00 3.11 8.15 69.62

French Civil
2.33 1.58 6.56 51.17
Law
German Civil
2.33 2.33 8.54 62.67
Law
Scandinavian
3.00 2.00 10.00 74.00
Civil Law
World 3.00 2.30 7.67 60.93

(49 countries)
84
Measures of Investor Protection:
Shareholder Rights
Proxy Shares not Cum. Voting Oppressed Preemptive % share
by blocked prior /proportional minority right to capital to
mail to meeting representation rights new issues call an ESM
Common Law 39% 100% 28% 94% 44% 9%

French Civil 5% 57% 29% 29% 62% 15%
Law
German Civil 0% 17% 33% 50% 33% 5%
Law
Scandinavian 25% 100% 0% 0% 75% 10%
Civil Law
World 18% 71% 27% 53% 53% 11%

(49 countries)
85
Antidirector Creditor Efficiency of Accounting

(0-6) (0-4) (0-10) (0-100)
Common Law 4.00 3.11 8.15 69.62

French Civil
2.33 1.58 6.56 51.17
Law
German Civil
2.33 2.33 8.54 62.67
Law
Scandinavian
3.00 2.00 10.00 74.00
Civil Law
World 3.00 2.30 7.67 60.93

(49 countries)
86
Creditor Protection Measures
World Means
0.8 0.81
0.7
0.6 0.58
0.55
0.49
0.5
0.78 0.45
0.4
0.60
0.3 0.56
0.2 0.45
0.1
0
No Automatic Secured CreditorsRestrictions to Management Creditor
Stay on Assets Paid First Reorganization Does Not Stay Rights Index
87
Measures of Investor Protection: Creditors
No automatic Secured Restrictions for Management

stay on assets creditors going into does not stay in
first paid reorganization reorganization
Common Law 72% 89% 72% 78%
French Civil
26% 65% 42% 26%
Law
German Civil
67% 100% 33% 33%
Law
Scandinavian
25% 100% 75% 0%
Civil Law
World 49% 81% 55% 45%

(49 countries)
88
Rights Rights the Standards
(0-6) (0-4) Judiciary (0-100)
(0-10)
Common Law 4.00 3.11 8.15 69.62
French Civil
2.33 1.58 6.56 51.17
Law
German Civil
2.33 2.33 8.54 62.67
Law
Scandinavian
3.00 2.00 10.00 74.00
Civil Law
World 3.00 2.30 7.67 60.93

(49 countries)
89
(0-6) (0-4) (0-10) (0-100)
Common Law 4.00 3.11 8.15 69.62

French Civil
2.33 1.58 6.56 51.17
Law
German Civil
2.33 2.33 8.54 62.67
Law
Scandinavian
3.00 2.00 10.00 74.00
Civil Law
World 3.00 2.30 7.67 60.93

(49 countries)
90
91
Outcomes
 Investor protection should be associated with higher number of
listed firms and higher valuation of capital and larger private credit
and bond markets, lower private benefits, ownership concentration
and earnings manipulations:
 Stock market capitalization / GDP
 Access to Equity
 Number of IPOs and listed firms
•Good laws &  Ownership Concentration
•Efficient  Private Benefits of Control
enforcement
 Earnings Manipulation
 Private Credit
92  Interest Rate Spreads
Consequences of Investor Protection:
Financial Markets
External Cap # Firms / # IPOs / Debt /GNP
/ GNP Mill. Pop. Mill. Pop.
Common Law 60% 35.45 2.23 68%
French Civil Law 19% 11.89 0.28 56%
German Civil Law 46% 16.79 0.12 97%

Scandinavian Civil
30% 27.26 2.14 57%
Law
World 40% 21.59 1.02 59%

(49 countries)
93
Shallower Financial Markets
0 20 40 60
2 2
GBR
FIN HKG
USA
Market Capitalization/GNP
1.5 CHE 1.5
SWE
NDL SGP
TAI
1 1
ZAF JPN
CAN
AUS
FRA
.5 GRC KOR CHL .5
BEL DEU ESP
KEN IRL DNK
INDPHL PRTMYS NOR NZL
IDNTUR THA
PEREGY ZWE ARG
BRA
MEX
ITA
COL
SRI NGA
VEN PAK AUT
0 UGY ECU 0
0 20 40 60
94
Rule of Law*Shareholders rights
Anti-Self-Dealing and
4
Ln Firms / Pop
Romania
Residual Ln(firms-to-population)
Bulgaria
Slovak Rep.
2
Jordan Iceland
Israel HongMalaysia
Kong
Egypt Latvia Sri Lanka Singapore
Luxembourg India
Pakistan Canada Australia
Jamaica
Spain Zimbabwe
Greece Lithuania
Korea (Rep.) New Zealand
South Africa
Croatia Chile
Ukraine Peru
Taiwan
Denmark Thailand
United Kingdom
0
Tunisia Panama Norway

Kenya El
Sweden
Switzerland Salvador
Czech Rep.
Finland
Bolivia
Philippines Nigeria Ghana
EcuadorHungary France Turkey
Japan Poland United States
Belgium Ireland
Kazahkstan
Portugal Morocco Indonesia
Colombia
Netherlands Austria
Germany
Uruguay
Venezuela Brazil Russia China
Argentina Italy
-2
Mexico
Uganda
-4
-.6 -.4 -.2 0 .2 .4

Residual anti-self-dealing index
coef = 1.0847465, (robust) se = .48839839, t = 2.22
• Partial-regression leverage plot of Log listed firms per million people against the
index of anti-self-dealing, controlling for Log GDPpc and efficiency of the judiciary..
Anti-Self-Dealing and
IPOs/GDP
United Kingdom
Taiwan
6
Greece
Hong Kong
Australia
Canada
4
Malaysia
Residual IPOs-to-GDP
Switzerland
2
Sweden
Korea (Rep.) Italy
Philippines Ireland Singapore
Kenya Zimbabwe Indonesia
Egypt
India
Pakistan
UnitedNigeria
States
0
Sri Lanka
Turkey Finland Thailand
Ecuador Portugal
Jordan Spain Peru South Africa
Colombia
Germany
Netherlands
-2
Venezuela Belgium
Brazil France Chile
Mexico Japan Argentina
Uruguay
Norway
Austria
Denmark Israel
New Zealand
-4
-.6 -.4 -.2 0 .2 .4

Residual anti-self-dealing index
coef = 4.1412864, (robust) se = 1.7922779, t = 2.31
• Partial-regression leverage plot of IPOs-to-GDP against anti-self-dealing in

regressions controlling for Log GDPpc and efficiency of the judiciary..
Shallower Credit Markets
0 10 20 30 40
1.5 1.5
JPN
DEU GBR
NDL
Debt Markets/GNP
1 FRA 1
THA ZAF NZL
USA MYS
AUS AUT
FIN ESP
CAN KOR
PRT CHL NOR ISR
SGP
ITA SWE
.5 MEX .5
IDN
BRA IRL BEL
DNK
PER PAK IND
GRC
COL ARG
TUR
PHL
0 0
0 10 20 30 40
97
Creditor Rights*Efficiency of Judiciary
Creditor Rights and
The Size of Credit Markets
Creditor Rights and Private Credit
Lower Ownership Concentration
0 20 40 60
.8 .8
GRC
Ownership Concentration
MEX
COL EGY
.6 LKA TUR .6
IDN
ITA
PHL AUT
BRA
PER ZWE
BEL ARG MYS HKG
VEN ISR ZAF PRT ESP
DEUTHA SGP NZL
DNK CHL
.4 NGA CHE
IND CAN .4
NLD IRL
PAK FIN NOR
FRA
SWE AUS
KOR
.2 GBR USA .2
TWN JPN
0 20 40 60
Rule of Law*Shareholders Rights
99
Corporate Governance and
Firm Valuation (median)
Low Shareholder Rights
High Shareholder Rights
12
1,4
10
1,2
1 8
0,8 6
0,6
4
0,4
0,2 2
0 0
100 Tobins' Q (MV/BV) Price/CashFlow
Institutional Investors say they are
willing to pay for good CG
McKinsey &
Company
Investor Opinion
Survey
101

o The Law
o Debt
o Dividends
o Boards
o Labor Market
o Banks
 Jawboning
 Proxy Fights
 Takeovers
102
Debt
 Free Cash Flow theory of debt.

 Free Cash Flow = Cash Flow in excess of that required to fund all NPV>0.
 Basic idea: Management would rather reinvest free cash flow than pay dividends
 Some mature industries have fewer investment opportunities  “cash-cows”.
 Examples. Tobacco. High earnings but declining demand.
 Jensen - Debt can be used to limit the availability of FCF to managers and commit them to
a repayment schedule.
103
Debt (2)
 Hart
 Liquidation is costly. Role for financial slack.
 However, too much financial slack is costly because managers over-invest.
 Optimal level of debt trades off the cost of wasting resources in NPV<0 against the
benefit of avoiding costly liquidation.
 Senior long-term debt can be used to limit the ability of management to issue claims
against existing assets.
104
Debt and Free Cash Flows
 ALLEQUITY firm expects cash-flows of $50M in each of the next two years.
 In addition, next year an investment opportunity will be available to invest $50 M in Year 1 in
exchange for cash-flows in Year 2 of:
 $60 M with probability 50%; or
 $40 M with probability 50%.
 Everyone knows whether the firm has a good or bad project BEFORE making the $50 M
investment. Investors are risk-neutral. The interest rate is zero.
 Managers come in two flavors:

(1) “Good” managers (only pursue NPV>0); and
(2) “Empire builders” (pursue NPV>0 and NPV<0).
1. How much is ALLEQUITY worth with a “good” manager?

2. How much is ALLEQUITY worth with an “empire builder”?
3. Can investors increase the value of the firm
105 by clever contracting? Can we use debt to
avoid NPV<0 (without destroying NPV>0)?

Debt and Free Cash Flows
 Assume that LEVERED is identical to ALLEQUITY except that LEVERED has $50 M in debt
maturing in Year 1 and $50 M in senior debt due in Year 2.
 How much is LEVERED worth with an “empire builder”?
 In Year 1, LEVERED receives CFs of $50 and pays it to its creditors.

 It then decides whether to invest in the new project. There are 2 scenarios:
1. The empire builder has a bad project; or
2. The empire builder has a good project.
1. How much is the firm worth if the empire builder with a bad project? Can he raise
finance?
2. How much is the firm worth if the empire builder has a good project?
3. Can debt reduce agency costs? 106


o The Law
o Debt
o Dividends
o Boards
o Labor Market
o Banks
 Jawboning
 Proxy Fights
 Takeovers
107
Dividends as a Bonding Device
Dividend payments are large relative to corporate resources
Managers pay a great deal of attention to the choice of dividends.
108
Question: Can dividends try to solve the agency problem?
Dividend payout policy in the U.S.A.
109
Dividends as Bonding Device
 Similar to debt but with less commitment.
 Unless there is a large cost to cutting dividends, dividends are not as much a commitment
as debt.
 Evidence:
 Outcome Theory: Dividends are a result of good legal protections where investors
use the law to force managers to pay some cash.
 Substitution Theory: Are dividends a mechanism that managers use to establish
reputations and then be able to access the market? In this case, we would expect to
see countries with poor legal protections paying more dividends.
110
Dividend payout policy in different countries
LLSV, JF
111

o The Law
o Debt
o Dividends
o Boards
o Labor Market
o Banks
 Jawboning
 Proxy Fights
 Takeovers
112
Boards of Directors Monitoring Managers
 In principle, the CEO is accountable to the Board.
 But, do boards really do anything?
 Statistical evidence suggests they do not, and usually collude with the CEO.
 Example: TWA during the Icahn takeover.
 In practice, directors are reluctant to challenge CEOs;

 Preserve value of old friendships/connections.
 Avoid reputation as a “loose cannon”.
 Directors who disagree with the majority may be asked to resign.
113
 Outside directorship and turnover of managers (Weisbach).
114  Twist: Boards act when firm performance lags that of industry peers.
The prob of getting fired is low when all firms in an industry are doing poorly.
Large Shareholders & CEO Turnover
115
 Is a CEO turnover good or bad news? (Kind & Schlapfer, 2011)
116
 In principle, the CEO is accountable to the Board.
 But, do boards really do anything?
 Statistical evidence suggests they do not, and usually collude with the CEO.
 Example: TWA during the Icahn takeover.
 In practice, directors are reluctant to challenge CEOs;

 Preserve value of old friendships/connections.
 Avoid reputation as a “loose cannon”.
 Directors who disagree with the majority may be asked to resign.
 International Evidence: They are likely to collude because the board looks like a
Christmas dinner (only family).
117  Example: Sweden, the owners are sitting in boards.
Boards of Directors Monitoring Management
Sweden, Board Seats of the Wallenbergs
Wallenberg , Associates Company / Position
Peter Wallenberg, Asea / Chairman
Vice Chairman of S-E-Banken Atlas Copco / Chairman
Ericson / Vice Chairman
Jacob Wallenberg, Atlas Copco / Member
Deputy chief operating officer of Enskilda Ericsson / Member
corporate division of S-E-Banken Stora / Vice Chairman
Marcus Wallenberg, Astra / Vice Chairman
Executive vice president of Investor SKF / Deputy Member
Claes Danlback, Asea / Vice Chairman
President of Investor Astra / Member
Electrolux / Member
Ericsson / Member
Incentive / Member
SKF / Member
Stora / Member
Source: Sven-Ivan Sundqvist,“Owners and Power in Sweden’s Listed Companies,” 1993.
The Wallenberg Family Tree
119
“Young, Educated and Almost Ready,”
120
“Young, Educated and Almost Ready,” (2010)
121
“Young, Educated and Almost Ready,” (2010)
122

o The Law
o Debt
o Dividends
o Boards
o Labor Market
o Banks
 Jawboning
 Proxy Fights
 Takeovers
123
Managerial Ownership
 Demsetz-Villalonga Summary
 All the studies put together do not give a strong view

 But, different measures of profits and ownership across papers
124
 Ownership structure may be endogenous, so hard to establish a link.
Managerial Ownership
 Managerial Ownership: Align interests of managers and shareholders.
Low %: Increasing managerial

ownership reduces conflicts of
Tobin’s Q interest.
Intermediate %: Increasing
managerial ownership facilitates
1 entrenchment (Armand
Hammer)
High %: Increasing managerial

ownership makes entrenched
“Low” “High” managers care increasingly
about max stock price.
125
Managerial Ownership 100%

o The Law
o Debt
o Dividends
o Boards
o Labor Market
o Banks
 Jawboning
 Proxy Fights
 Takeovers
126
Incentive Contracts
 Pay-for-performance may align managerial incentives with those of shareholders.
 Jensen and Murphy (HBS)  for every $1,000 increase in shareholder value, CEO wealth
increases by $3.25.
 Probably not sufficient to restrain the consumption of perks; but
 May be enough to avoid NPV<0.
 Pay-per-performance mitigates the incentives to undertake actions with mixed motives (eg,
bad acquisitions). It does little to avoid taking-of-property problems and conflicts of interest.
127
Executive Compensation and
Dividend Policy
Setup question 1: What happens to the price of a stock when the company pays out a
dividend?
________________________________________
Setup question 2: What happens to the price of the stock when the company buys
back shares?
________________________________________
Key Question: Assume that you are the CEO of the firm and that you own a large
number of options to buy shares at the price before the company decides if they should
pay out a dividend or buy back shares.
Would you prefer the firm to pay dividends or to repurchases shares? Why?
____________________________________
_____________________________________________________________
128
Incentive Contracts:
 Problems:
 Managers may be risk-averse (i.e., incentive contracts may be very costly).
 Compensation is set by the Board of Directors. Who chooses its members?
 Enormous opportunities for self-dealing. For example, Yermack presents evidence
that CEOs award themselves options when they know that good news are coming and
after bad news is released.
 Managers are rewarded for luck (Sendhil).
 CEOs who gave shareholders the least for their pay (Business Week):
Total Pay Shareholder
(millions) Return
 1 CHARLES WANG Computer Associates $698.2 -63%
 2 MICHAEL EISNER Walt Disney 699.1 -10
 3 HENRY SILVERMAN Cendant 212.6 -72
4 PETER KARMANOS Compuware
 129 112.6 -61
Incentive Contracts:
 Tesla CEO Elon Musk was excluded from

EPI’s CEO pay analysis.
 His 2021 earnings would skew the overall
CEO picture, as he exercised $23.5 billion
in stock options expiring in 2022.
 His pay was
nearly 1,000
times the
average among
CEOs of large
companies.
 Including his pay
would’ve led to
an increase in
CEO pay of
more than 300%,
130
Caps on Executive Pay?
131  http://video.nytimes.com/video/2009/02/04/business/1231547065766/obama-and-geithner-on-executive-pay.html
"These People Are Idiots" Executive Compensation Bill Discussions
Sen Claire McCaskill
132
 http://www.youtube.com/watch?v=yt90KUwCCoE
Caps on Executive Pay?
133
Banks’ CEO Executive Compensation
134  http://www.thedailyshow.com/video/index.jhtml?videoId=218378&title=american-grandstand-bank
 http://www.indecisionforever.com/video/index.jhtml?videoId=218378

o The Law
o Debt
o Dividends
o Boards
o Labor Market
o Banks
 Jawboning
 Proxy Fights
 Takeovers
135
Labor Market (ex-post settling up)
Percentage of top managers of dividend-reduction and comparison companies who obtain additional
directorships in Fortune companies from the dividend-reduction announcement to the proxy statement for
the third fiscal year ending after the announcement, and from the proxy statement for the third fiscal year
ending before the dividend-reduction to the announcement. Dividend reductions were announced in the
period 1979-83.
Panel A: Percentage of managers who obtain at least one additional directorship in

a Fortune company from the dividend-reduction announcement to the
proxy statement for the third fiscal year ending after the announcement
Obtain at Least One New Do Not Obtain Any New N
Directorship Directorship
Dividend Reduction Managers 10.5% 89.5% 133
Comparison Managers 22.6% 77.4% 124
Chi-Square2=6.82
Panel B: Percentage of managers who obtain at least one additional directorship in

a Fortune company from the proxy statement for the third fiscal year
ending before the dividend-reduction to the announcement
Dividend Reduction Managers 17.8% 82.2% 135
Comparison Managers 17.2% 82.8% 128
Chi-Square2=0.02
136
Kaplan & Rehaus.
Labor Market (ex-post settling up)
137
Kaplan & Rehaus.

o The Law
o Debt
o Dividends
o Boards
o Labor Market
o Banks
 Jawboning
 Proxy Fights
 Takeovers
138
Large Creditors
 Banks are important investors in some countries. The have the power: (1) to throw the firm
into bankruptcy; and (2) undertake short-term lending.
 Key  with shareholders  concerted action is not necessary to throw a firm into
bankruptcy.
 Initial Evidence
 Japan: (Kaplan and Minton, 1994)  Management turnover in response to poor
performance when the firm has a main bank.
 Germany: (Gorton and Schmidt, 1996) Banks improve company performance more
than other blockholders in the 1970’s (although not in the 1980’s).
 U.S.
 (De Long, 1991) J.P. Morgan created value for the companies it invested in.
 (Gilson, 1990) Banks play an important CG role in bankruptcies.
 Recent Evidence
139  Japan: Suzuki & Cobham (2005)
 Germany: Dittman, Maug, Schneider (2010)
Bank Monitoring
 Suzuki and Cobham (2005):
140
Bank Monitoring
 Suzuki and Cobham (2005):
141
Bank Monitoring
 Frank and Mayer: Ownership of Banks in Germany
142
Bank Monitoring
 Dittman, Maug, Schneider (2010): Ownership of Banks in Germany
143
Bank Monitoring
 Dittman, Maug, Schneider (2010): Effect of Banks on bank debt
144
Bank Monitoring
 Dittman, Maug, Schneider (2010): Effect of Banks on M&A advisory
145
Bank Monitoring
 Dittman, Maug, Schneider (2010): Effect of Banks on Management Compensation
146
Bank Monitoring
 Dittman, Maug, Schneider (2010): Effect of Banks on Tobin’s Q
147
Bank Monitoring
 Dittman, Maug, Schneider (2010): Effect of Banks on ROA
148

o The Law
o Debt
o Dividends
o Boards
o Labor Market
o Banks
 Jawboning
 Proxy Fights
 Takeovers
149
Large Shareholders: Jawboning
 Benefits of large investors: Incentives to monitor (free-rider problem).
 Examples of large investors:

 Pension funds (eg, CALPERS and Lens Fund);
 Mutual funds & Activist Hedge Funds;
 Raiders  Takeovers (temporary concentration of ownership);
150
Institutional Investor Ownership; U.S. stock markets
Source: Gillian, S.L. & Starks, L. T. 2007.The evolution of shareholder activism in the United States, Working paper.
Institutional Investor Ownership; U.S. stock markets
Institutional Investor Ownership; World stock markets
Corporate Governance proposals
by Institutional Investors:
Source: Gillian & Starks, The evolution of shareholder activism in the United States
Voting outcomes for Corporate Governance
proposals
Mutual Fund Connections and Voting with Management
Source: Cvijanovic, Dasgupta and Zachariadis (2016)
Mutual Fund Connections and Voting with Management:
Effect of Business Ties on Voting with Management
Mutual Fund Connections and Voting with Management:
Management, Shareholder & Contested Shareholder Proposals
Large Shareholders: Activist Investors
 In the 1980s activists were called corporate raiders. Today activism is mainstream and a
preoccupation of America’s boardrooms.
 Since 2011 activists have:
 helped depose the CEOs of Procter & Gamble and Microsoft,
 fought for the break up of Motorola, eBay and Yahoo (its stake in Alibaba)
 won board seats at PepsiCo and Bank of New York Mellon
 Organized consolidation in the pharmaceutical industry, and taken on Dow Chemicals
and DuPont.
 Age, status or systemic importance offers no protection. Activists have also:
 Removed the management of the oldest firm on the NYSE: Sotheby’s.
 Won a board seat on Bank of New York Mellon, a too-big-to-fail bank at the heart of
the global financial system.
 Attacked the world’s most valuable company: Apple (now 2nd).
 The chairman of one of Silicon Valley’s biggest firms admits, “We think about an attack all
159
the time.”
Activists are growing THE ECONOMIST
Activist investors go after a German

Call to action (April 2017)
industrial icon (May 2018)
Investor activism is surging in Thyssenkrupp splits under pressure from
continental
160
Europe activists. The aim was to thoroughly shake up the
Third Point, Corvex and Elliott are just the beginning last of the country’s unreformed conglomerates
Elliott Management takes $2.5B stake in SoftBank
FT: Feb 7, 2020
• Elliott wants SoftBank to buy back $20 billion

worth of its stock, believing it trades at a 60%
discount to net asset value, and Corporate
Governance changes.
• Pressure on SoftBank to liquidate its larger
holdings, such as its 25% stake in Alibaba Group.
• It also could slow Vision Fund 2 investments until
SoftBank holds at least a first close on third-party
commitments (or Vision Fund 1 proceeds).
• Elliott would prefer SoftBank spend its balance
sheet cash on stock buybacks, not on private
company investments.
161
• https://www.youtube.com/watch?v=tflK3GtL9Jc
Short seller Hindenburg accuses Adani of “largest
con in corporate history” Jan 25, 2023
• Adani’s fortune was at $140bn thanks to the gains of the

7 listed companies he controls. That encouraged new
acquisitions: Israeli port, Indian TV-news network and
the second-largest cement producer.
• Hindenburg Research, an American short-seller, released
“Adani Group: How the World’s Third-Richest Man is
Pulling the Largest Con in Corporate history”. It alleges
that share prices have been artificially inflated.
• It describes a complex edifice: 7 Indian-listed companies
sitting atop 578 subsidiaries. In 2022, these engaged in
6,025 related-party transactions. A complex system, with
multiple companies, many in foreign jurisdictions,
which “have no obvious signs of operations”.
• To manipulate the listed firms’ prices and shift money
onto162
their balance-sheets for “the appearance of financial• https://www.youtube.com/watch?v=9OBnYqS43v0
health and solvency” amid high debt & thin liquid assets• https://www.youtube.com/watch?v=gsl0IS9dkQQ
Activists are growing
 In 2023, there are over100 hedge funds engaged in activism. Activist funds have over $200
billion of assets under management. They have become an “asset class” that continues to
attract investment from major traditional institutional investors.
163
164
165
Activists are growing,.. But not equally
166
167
What do Activists ask for?
168
Large Shareholders: Proxy Fights
169
Activists’ Success Rate
170
Activists’ Success in Getting Board Seats
171
Large Shareholders: Proxy Fights (Contests)
 Definition: Shareholder meeting where an opposition candidate runs.
 Evidence (average excess return):

 Announcement of proxy fight: +4.85%
 Announcement of outcome:
 Dissident gains control: +2.60%
 Dissident gains minority: -0.24%
 Dissident goes away: -5.45%.
 Success rates:
 Proxy fight for full control: 40.4%;
 Proxy fight for partial control: 77.3%.
 Problems:
 Incumbent board may delay the release of the firm’s list of shareholder names and addresses;
 Incumbent uses firm’s money to pay for advertising against dissidents (who use their own
172
money).
Proxy Fights & Performance
173
174
175
Large Shareholders: Takeovers
 Poor management  low earnings  low stock price:

 It may attractive to buy the firm and fire the manager.
 Evidence:
 Stock prices rise when a takeover is announced. Targets do, indeed, have low
valuations (on average, Tobin’s Q is 0.5 for targets and 1 for the market).
 Companies with larger shareholders have higher Q ratios;
 Management turnover is more sensitive to performance
176
177
178
Problems:
(1) Require a liquid capital market;
(2) Very expensive
(3) Politically vulnerable
(4) Acquisitions can actually increase agency costs
179
Blocked Takeovers
Jan 23rd, 2020. The Economist

 Mr. Yoshiaki, activist investor,
launched a hostile bid for Toshiba
Machine
 Toshiba blocked takeover issuing
warrants to shareholders (poisson pill)
 Toshiba
180 shareholders OK anti-
takeover measures.
Blocked Takeovers
181
Problems:
(1) Require a liquid capital market;
(2) Very expensive
(3) Politically vulnerable
(4) Acquisitions can actually increase agency costs
182
Prof. Florencio Lopez de Silanes

SKEMA Business School and U.S. NBER 183

o The Law
o Debt
o Dividends
o Boards
o Labor Market
o Banks
 Costs
184
Large Shareholders: Costs
 Costs of large investors:

1. Loss of benefits of diversification;
2. Monitoring may yield greenmail for the large investor but few benefits for
dispersed shareholders;
3. May collude with controlling group to expropriate minority shareholders;
4. Who watches the monitor? (May have agency problems of their own).
185
The “Widely Held” Myth
 Berle and Means (1932) US: the prevalence of widely held corporations in the ownership of capital
is dispersed between small shareholders, yet control is concentrated in the hands of managers.
 The B&M image has been put to rest:
a) US: Even among the largest firms, there is a modest concentration
 Several hundred publicly-traded firms with majority shareholders.

 Management ownership today is higher than in the 1930s.
b) Outside the US:
 Significant concentration of ownership in rich countries.

 In developing economies (Asia, Latin America), ownership is also heavily concentrated.
c) In many countries, large corporations have large shareholders who are active in corporate
governance.
d) Families are the rule of the game outside the US and the UK.
Microsoft Corporation (USA)
Microsoft Corp.
Bill Gates Paul Allen Steven Ballmer

23.7% 9% 5%
(Chairman & CEO) (Co-founder) (Executive VP)
Market Cap:98,654M TOP # 4

Business: computer software
CB/CEO: Bill Gates At 20%:Bill Gates
Founded by Bill Gates and Paul Allen in
1975 At 10%:Bill Gates
Samsung Electronics (South Korea)
Samsung Electronics
(Group Chairman: Lee Kun-Hee)
(Chairman: Kang Jin-Ku)
Lee Kun-Hee Samsung Life Samsung Co Cheil Jedang Shinsegae Dept Stores Cheil Wool Textile Co Joong-ang Daily News Joong-ang Develop.
8.3% 8.7% 4.3% 3.2% 1.9% 1.6% 1.0% 0.6%
Lee Kun-Hee Lee Kun-Hee Samsung Life 49.3% Samsung Group 48.3% Joong-ang Daily New
49% Samsung G 48% Joang Ang
Lee Kun-Hee Cheil Jedang Lee Kun-Hee Samsung Life Lee Kun-Hee
9.1% Lee Kun-Hee 14%14.1%Chail
Cheil Wool
Wo.Textile C
15.0% 11.5% 9.2% 9% 14.1% 22.7% 6.9% 9.3%
Lee Kun-Hee Lee Kun-Hee Cheil Jedang Lee Kun-Hee Cheil Jedang
14.1% 15.0% 11.5% 15.0% 11.5%
Mkt Cap: 12,164 Mill
Business: Semiconductors/Home
Top # 2
Appliances, etc. 3674. Lee Kun-Hee Lee Kun-Hee
At 20%: Widely Held
Source: KIS. 14.1% 14.1%
Year Founded: 1973 At 10%: Lee Kun-Hee
Electrabel SA (Belgium)
Electrabel
Powerfin 16.2%C&V
26.34%C&V
27.5%C&V
Tractebel 4.28%
59.96%C&V
Genfina Finance et Participations Electrafina 7.58%

8.02%C&V 0.25%C&V 19.97%
Generale de Belgique Sofina Generale des Eaux Groupe Bruxelle Lambert

10.17%
60.0%C&V 40%C&V 23.96% 46.57%
(ARS) (France)
Compagnie de Suez Frabepar Cofiblan Family Boel/Solvay Pargesa Royale Belge

9.53%
49.38%C&V 8.96%C&V 3.81%C&V (see graph #2) 49.65% 5.72%
(France) (100% subs Suez) (see graph 3)
Frere-Bourgeois Royale Vandome

"Member Suez" (see graph # 3) 52.11%
BBL
Groupe Bruxelle Lambert UAP

Mkt Cap: 12,937,602 TOP # 1 25.10% 74.90%
Business: 4911 Electric Services (ARS RB) (ARS RB)
Year Founded: 1905 At 20%:Suez 14.30%
Name of the Founder: Compagnie de Suez BNP

Source for Ownership: BBL unless otherwise noted. At 10%: Suez 4.9% 17.55%
Onwership Patterns Around the World
Control of Largest Publicly Trated Firms (20% control cutoff)
40%
35%
30%
25%
20%
15%
10%
5%
0%
Widely Held Family State W. H. Financial W. H. Corporation
Onwership Patterns Around the World
Control of Medium-Sized Publicly Trated Firms (20% control cutoff)
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
Widely Held Family State W. H. W. H.
Financial Corporation
Pattern of ownership around the world
Source: Holderness, C.G. 2009. The myth of diffuse ownership in the United States, Review of Financial Studies, 22 (4), pp. 1377.
Share of Controlled Firms around the World
Source: Aminadav & Papaioannou, 2020. Corporate Control Around the World, Journal of Finance.
Share of FAMILY Controlled Firms around the World
Share of GOVERNMENT Controlled Firms around the World
Pattern of ownership around the world
Who Manages Controlled Firms?
How are Firms Controlled?  Pyramids
 The Economist, April 2015:
Hutchison Whampoa Ltd
(Hong Kong)
Hutchison Whampoa
(Ch: Li Ka-shing)
(Vice Ch: Richard Li)
Cheung Kong Hldgs

43.9%
(Ch & Founder: Li Ka-shing)
Mkt Cap $:22,014 Million. Family Li

Business: Business Services (Ka-shing; Richard; Victor)
Yr Founded: 1977.
35%
Founder: Hutchison Intl’ (founded by John Hutchison in
1880) merged with Whampoa Dock (1861). Cheung Kong
became a large shareholder in 1979. TOP # 3
At 20%: Li Ka-shing and sons

At 10%: Li Ka-shing and sons
Ownership Structure of CityChamp Dartong
Ownership of the Ayala Family in

Laguna Tech Inc =
= 51%*77%*58% = 22.7%
Example: Ownership Structure of
Automated Electronics (Philippines)
Example: Ownership Structure of
Automated Electronics
(Philippines)
Ownership of the Ayala Family in

Automated Electronics =
58%*74%*78%*30% = 10.1%
Pyramids and Incentives.
Firm D
50%
Firm C
50%
Firm B
50%
Firm A
50%
Ultimate Owner
 Suppose Ultimate Owner owns A owns B owns C owns D, each with a 50% equity stake.
 Ultimate Owner controls all four firms.
 If D had a great year and wanted to distribute a $100 dividend
 How much will the Ultimate Owner get as dividends?
 Is paying a Dividend good for the Ultimate Owner? What else could do?
Pyramids and Incentives.
50% Firm D
50% Firm C
50% Firm B
50% Firm A
Ultimate Owner
 Suppose A owns B owns C owns D, each with a 50% equity stake.

 Ultimate Owner controls all four firms.
 But $100 dividend by D  $6.25 to ultimate owner.
 Pyramids generate incentives to tunnel.
Test for Tunneling
 Predictions generated by optimal diversion:
1. Group firms should under-react to shocks to their own profits. The controlling
shareholder will divert a fraction of the shock to increase private benefits.
 For example, imagine that industry conditions improve justifying, in the absence
of tunneling, a $100 increase in the earnings of firm D.
 If tunneling takes place, the earnings of firm D should increase by less than
$100.
 Moreover, if there is tunneling, the earnings of firm C should also increase.
 Finally, the earnings of firm D should not be affected by positive shocks to the
earnings of firm C.
2. Tunneling will be more extreme in lower down companies. The insider will divert
cash from those firms where she has a lower cash exposure.
Sensitivity to Own Shock
 A one-rupee shock leads to about a one-rupee (1.05) increase in earnings for a

stand-alone firm.
 For a group firm, it leads to 0.3 rupee smaller increase, that is only a 0.75 rupee
increase.
Sensitivity to Own Shock Within Groups
 Group firms where director equity is higher are more sensitive to their own
industry shock.
 Each one-percentage point increase in director equity increases the sensitivity to a
one-rupee industry shock by 0.03 rupee.
Conclusions
 The separation of ownership and control is efficient.

 The CEO has specialized knowledge. Shareholders have capital.
 CEOs have discretion over business decisions because shareholders cannot write contracts
that spell out exactly how the CEO is to behave in each state of the world.
 CEOs can use their control over corporate policy for the pursuit of private benefits.
Examples include:
 Consumption of perks;
 Taking corporate opportunities;
 Self-dealing;
 Actions with mixed motives
 Investing in projects that fit the manager’s expertise rather than in projects that
maximize the value of the firm.
 Resist value-enhancing takeovers;
208
 Excessive executive compensation.
Conclusions (2)
 The law is the main tool to limit opportunistic behavior.

 Courts can successfully address opportunistic behavior that is examined through the
lens of fiduciary duty (corporate opportunities and self-dealing).
 Courts are less adept at remedying opportunistic behavior that falls under the purview
of the business-judgement rule (empire building, executive compensation, etc).
 Other tools for addressing opportunistic behavior include:

 High leverage and dividend payments;
 Independent boards;
 Pay-for-performance; and
 Monitoring by large shareholders and takeovers.
 Large Shareholders may represent their own interest, so they engage in:
 Expropriation from other investors, pay themselves special dividends, exploiting
209 business with their own firms, Pursue their own inefficient objectives, etc...
What Can Go Wrong?
STOCKHOLDERS
Have little control Managers put their

over managers interests above
stockholders.
Lend Money Significant Social Costs

BONDHOLDERS INSIDERS SOCIETY
Bondholders can Managers may ignore social costs
get ripped off while pursuing stock price max
Delay bad news or Markets make

provide misleading mistakes and can
information over- or under-react
210 FINANCIAL MARKETS

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Agency Conflicts and Corporate Governance

Prof. Florencio Lopez de Silanes

Taxonomy of Agency Conflicts and Tunneling.

Evidence of Agency Costs.

Solutions to the Agency Problem.

(1) Cash raised from investors

Hire & fire managers Maximize

Lend Money No Social Costs

BONDHOLDERS Insiders SOCIETY

Reveal information Markets are efficient and

Why Stock Price Maximization Works?

Stockholders hire managers to run their firms for them

 In the Perfect M&M world, the objective in decision making is to

 Question. What were Board Members doing?

Hire & fire managers Maximize

Lend Money No Social Costs

BONDHOLDERS Insiders SOCIETY

Reveal information Markets are efficient and

 Nature of Moral Hazard problems:

 What are relationship-specific investments?

How concerns about opportunism affect contractual relationships?

 Grossman & Hart:

 The separation of ownership and control is beneficial but costly.

 Next, we consider different examples of agency problems.

Taxonomy of Agency Conflicts and Tunneling.

Evidence of Agency Costs.

Solutions to the Agency Problem.

 “Argentine Small Holders Get No Respect”—WSJ

The Flavors of Agency Conflicts:

1. Transfer corporate resources to the insider.

2. Diluting outsiders’ share in the firm.

 Public Corp is worth $100 Billion.

 The CEO owns $10 M in stock.

 Buying Lear jets destroys $________ M in firm value.

The Flavors of Agency Conflicts:

1. Transfer corporate resources to the insider.

2. Diluting outsiders’ share in the firm.

Bought properties and leased them to his

The Flavors of Agency Conflicts:

1. Transfer corporate resources to the insider.

2. Diluting outsiders’ share in the firm.

Transfer of TV Nova’s signal to rival operation

Sale of TSI for $30 million in cash

 In August 1999, Telefónica de Chile

 Analysts valuated Telefónica.Net around

 Stock prices plummeted in the

 On November 17, 1999 Terra Networks went

 In the U.S., TN’s IPO was priced at US$13.41

 After the IPO, Spain’s Telefónica retained

 He had close ties to the socialist government of

 The rapid rise in the compensation of

 He was forced to step down in 6/2000 over

The Flavors of Agency Conflicts:

1. Transfer corporate resources to the insider.

2. Diluting outsiders’ share in the firm.

 The Public Corp pays Insider for her role as CEO.

 Note: We can’t make it illegal to compensate CEOs.

Note: We can’t make it illegal to compensate CEOs.

Tunneling comes in two flavors:

1. Transfer corporate resources to the insider.

2. Diluting outsiders’ share in the firm.

 Examples of actions with mixed motives.

 Survival of the company with themselves at the helm.

44  Empire building.  Size   CEO’s prestige, power and compensation.

1. Insiders’ dividend income falls by $ΔsProfits as cash is siphoned off.

 Tobin’s Q = PV(profits)/Value of assets = (1-s)RI/I