Week 8

• information asymmetry

• close link between firm characteristics (size, risk, life-cycle, profitability etc.) & its capital structure choices

1) Irrelevance theories: Capital structure is irrelevant to firm value

2) Relevance theories: Capital structure is relevant to firm value

• Trade-off theory

• Pecking order theory

• Market timing theory

1) Carrot: Reward CEOs with money for “good” performance

2) Stick: Threaten to punish CEOs for “bad” performance

1) Internal: the board of directors & large institutional owners

2) External: threats of takeover & threats of product markets

1) Owners (ownership)

2) Managers (control)

• Agency problem refers to difficulties that financiers have in assuring that their funds are not expropriated or wasted on unattractive projects (Shleifer and Vishny, 1997)

  
  

• because of incomplete contracts

  —> moral hazard

• Shareholders want CEO to maximize wealth

• CEO wants: job security, publicity, money, career prospects etc.

  —> divergent interests between managers and shareholders

• align interests of owners & managers

1) Managerial risk aversion

• risk averse CEOs: Forego risky but high NPV projects —> common in reality

—> need a governance mechanism to motivate these CEOs to work harder

2) Managerial unethical behavior

• reckless & fraudulent CEOs

—> need a governance mechanism to punish these CEOs for bad behavior

There is NO “one-size-fits-all” governance!

e.g.

• employees

• consumers

• suppliers

• general public

1) Enron: accounting misconduct

2) Wells Fargo: created fake consumer accounts

3) Primark: used child labor

1) governance by maximizing shareholder interests

• making sure CEOs act in shareholders’ best interests

2) governance by ensuring equitable treatment of all shareholders

• foreign and domestic shareholders should receive the same treatment

• major and minor shareholders should receive the same treatment

3) governance by maximizing stakeholder interests

• making sure employees, suppliers, customers, the environments and the society are protected

1) Shareholders: someone who holds shares of the company

2) Stakeholder: someone who is involved in or affected by a project

1) Carrot

• Reward CEOs with money for “good” performance

2) Stick

• Threaten to punish CEOs for “bad” performance

L1: Pay level

L2: Performance - pay sensitivity

L3: Pay structure

• CEO compensation incentivizes managers to take effort

1) Fact: CEOs account for 91% of a frims investment policies. Their annual pay is 0.05% of the firm’s market capitalization

2) focusing on pay level does not align the interests between managers & owners

3)

• the teachers are happier, BUT

• remain equally lazy —> pay rise has NO effects on student’s learning experience, test scores, or success

• CEO compensation is an important mechanism to reduce agency costs

• focus on only pay levels is misplaced

1) What it is? Make CEO pay sensitive to firm’s performance

2) How it works? Pay the CEO with the firm’s stock instead of cash

• CEOs will work harder to increase share prices to gain higher compensation

• pay-performance sensitivity is a powerful way to cut CEO slack

3) Disadvantages/ dark side

• Edmans, Fang and Lewellen (RFS 2017): CEOs reduce investments (R&D, CAPEX) to inflate stock prices when they need to redeem their shares

• Burns & Kedia (JFE 2008): Sensitive pay is linked to accounting misconduct

• firms increasinly pay CEOs with more incentive-based compensation

Pay structure

• pay duration AND

• pay ratio

Pay duration (period):

• whether number of shares that a CEO receives is based on short- or long-term

• powerful way to align the CEO with short-or long-term value

• Elon-Musk pay policies: Tesla’s market value Must exceed $100 billion by 2028, otherwise Musk receives nothing:

  • Encourages Musk to focus on very long-term value creation policies (10 years)

  • suits Tesla as it has a huge growth potential

    -> may not be suitable for other firms

• The CEO pay ratio compares the overall compensation of the CEO to that of the typical employee

• CEO pay ratio is computed by dividing the CEOs remuneration by the median employees remuneration

1) firms with a greater CEO-worker pay ratio perform better (Mueller, Ouiment, Simintzi, 2017)

2) von Wachter (2017): Larger pay gap is linked to a) higher employee productivity & b) riskier firm policies, for c) innovative & complex firms

3) Kale et al. (2009): Larger pay gap between CEO and other executives contributes to better firm performances in US (Tournament effect)

4) Kini and Williams (2012): Higher tournament incentives lead to greater risk taking

1) CEO compensation is a power means to reduce agency conflicts & encourage CEO effort

—> as long as you know how to pay…

2) What matter in CEO pay is not how much you pay, but how you pay it

• CEO turnover (=CEO Wechsel)

• replace CEO for poor performance

• (Jensen & Murphy, 1990): negative realtionship between firm performance & likelihood of CEO turnover

  -> Negative relationship (one variable increases as the other decreases and vice versa)

1) The Bord of Directors

2) Large shareholders

3) Other external mechanisms

• A group of individulas that are elected as representatives of the shareholders to ensure that the CEO acts in shareholder’s best interest

1) monitor and

2) give advice to the CEO (on behalf of shareholders)

• Chairman

• Outside directors/ Independent directors

• Inside directors (e.g. executives, representatives of large shareholders…)

—> Executive directors and non-executive directors

• Independent/ outside directors are those that are independent from the firm’s CEO (management), i.e., they do not have any family connection, commercial or financial relationship with the CEO (management)

• being “independent” from the CEO allows these directors to objectively monitor the CEO

• A board of directors that is independent from the CEO is a hallmark of a well-functioning corporate governance

1) Nominating: Hire & fire CEOs

2) Compensation: Pay CEOs

3) Audit: Accounting & Auditing policies

4) Risk (optional)

• consists of at least 50% outside directors

• All members of nomintating & compensation committee must be outside directors

• Key finding: porbability of fraud is lower when the board is more independet

Enron:

• one of the world’s leading electricity, natural gas, communications and pulp and paper companies

• America’s “Most Innovative Company” for 6 years by Fortune

• 2000 staff; $101 billion claimed revenue in 2000

Accounting Scandal:

• in 2001 it was discovered that many of Enron’s recorded assets and profits were inflated or even wholly fraudulent and non-existent

• scanal caused the dissolution of its auditor, Arthur Andersen

The Enron’s irony:

• board of Enron in 2001: 14 out of 17 members are independent directors

• Its audit committee is fully independent & is chaired by a Stanford accounting professor

Some “independent” directors on Enron boards:

• received charitable donantions from Enron

• bought assets from Enron

• received $72.000 for their advice

—> independent directors are not “truly” independent

• when they are college buddies with the CEO

• when they used to work in the same firm with the CEO

• when they owe the CEO a favor, e.g., for recommending her to join the board

—> According to: “Coles, Daniel, Naveen (2014, RFS) and Khanna, Kim, and Lu (2015, JF) the above factors lead to reduced monitoring and increased fraud

Implication:

• it is difficult to achieve a “perfect” corporate governance in practice!

1) board independence is the hallmark of a healthy corporate governance

2) due to various factors (outsiders with heterogeneous background, private incentives, social influence), it is difficult to achieve true board independence in practice

• Demographic composition (e.g., Gender age, nationality…) of board of directors matters to firm outcomes (e.g. performance/ risks/ policies)

• Benefit: Generate higher creativity, innovation and boost decision-making quality

• Cost: Generate conflicts and distract decision making process

1) Adams and Ferreira (JFE 2009): Gender-diverse boards allocate more efforts to monitoring the firm

2) Bernile, Bhagwat and Yonker (JFE 2018): Diverse boards adopt more persistent and less risky financial policies; reduce stock volatility; have more efficient and innovative investment

3) Oleksandr, Yin and Zhang (IRFA 2018): Board age diversity generates conflicts due to different personal values and weakens bank performance

1) Large institutional investors often own shares of many firms in several different industries

2) they are actively involved in the day-to-day activities of the firm by:

• (Voice) Forcefully replace the CEO of the board of directors

• (Exit) Threaten to sell the firm’s shares

• US: less common

• Germany: large commercial banks

• Most of Europe (e.g. Italy, Finland, Sweden), as well as Latin America, East Asia, and Africa: common

1)

• CEO of that firm are 53% more likely to engage in “pointless” mergers to build up their empire -> these mergers destroy an average of $1.67 billion of firm value

• In addition, these CEOs are

  a) less likely to be fired for having poor performance

  b) more likely to cut dividends

  c) more likely to grant themselves options rewards

2) Implications:

• Large shareholders are important governance mechanism

• when the cat is away, the mice will eat your money!

1) threats of being taken over

2) product market competition

• if CEO does not efficiently utilise the firm’s resources to generate shareholder wealth, some other companies will try to forcefully buy it via a hostile takeover & try to repalce the CEO

  -> also a governance mechanism

• hostile takeovers impose significant distress not just on ly to the CEO but also to other stakeholders (e.g. employees, suppliers, customers)

  -> many US states passed laws in the late 1980s to restrict it

• worker wages [especially for those of white-collar workers (=Angestellen)] rise

• overall productivity and porfitability decline

• less creation of new plants

• less destruction of old plants

• Two industires: Industry A only has 1 monopoly; Industry B has 10 firms basically selling the same product

• Obviously, CEOs of frims in industry B are under greater pressure to get their things right

  • suppliers & customers in industry B will be able to tell which firm sell high-quality products

  • investors in industry B will be able to tell what constitutes “appropriate” profitability

  -> governance problems are more sever for firms in industry A