Corporate Finance

Lecture Notes
Emmanuel Letete
Lecture 5

Corporate Governance and Executive Compensation, November

2016

Emmanuel Letete

Corporate Finance

Lecture Outline

We will discuss dierent aspects related to the corporate governance of

corporations, as well as the benets and costs of socially responsible
corporate behavior.
We will consider the extent to which corporate governance aects the
value of the rm.
Later we will consider the managerial compensation. How much should
we pay managers/executives in order to increase the value of the rm?
Should they be paid more or less? What does evidence say?

Emmanuel Letete

Corporate Finance

Reminder: Corporate Relationships

(1) Recall we said the rm has relationships with:
Investors or Creditors
Suppliers
Employees & managers
customers, government
(2) How do we understand these relationships? We appear to the Economics
theory and apply economics to understand these relationships.
The economics of information
Contract theory
Three essential informational problems: Hidden actions, Hidden
information and Non-veriable information
(3) At the center stage of the rm/investor relationship are: How are rms
managed? How are rms nanced? How do informational problems aect these
questions?
Emmanuel Letete

Corporate Finance

On Corporate Governance Specically we consider:

Meaning of corporate governance.
Separation of ownership and control.
Problems inherent in corporations/companies that need corporate
governance.
Dealing with these problems (Models proposed).
The benets and costs of socially responsible corporate behavior.
We will consider the extent to which corporate governance aects the
value of the rm.
Practical experience and KING III and IV Application to Firms in
Southern Africa and Lesotho.
Denition: What is corporate governance? The system of controls,
regulations and incentives designed to make management act
in the best interests of the shareholders. And therefore any
discussion of corporate governance is a story of conicts of
interests and attempts to minimize them. We could also argue
that corporate governance refers to a set of institutions that
serve to regulate how a given set of individuals manage other
individuals property (where property can be tangibles or
intangibles)
Emmanuel Letete

Corporate Finance

Corporate Governance & some Issues of concern.

Then how do suppliers of nance to a rm make sure they get returns on their
investments.
Investors
Creditors
How can corporate insiders credibly commit to returning funds to outside
investors, thus attracting external nance
Recall that Insiders include management and sometimes current owners
Indeed corporate governance is again an issue of popular concern in the
world today. Enron, Tyco, President Zuma Inkandla case, BID-VEST case
in Lesotho, Agriculture Fertilizer Tender, World-com, Global Crossing,
among others have become household names and talks of the day and of
course synonyms of corporate scandals.

Emmanuel Letete

Corporate Finance

Corporate Governance & some Issues of concern.

Hundreds of billions billions US$ have been lost in the process. Some
estimates show that WorldCom's Collapse alone wiped out US$ 126.8
Billion.
Although largely overshadowed by more dramatic world events, issues of
corporate governance have played a role in International Politics, Local
Politics etc. Several Presidents including the US president/ Prime
Ministers have faced several inquiries into their business dealings.
However, corporate Governance is not new. In 1776, Adam Smith was
writing about corporate governance.

Emmanuel Letete

Corporate Finance

Corporate Governance & some Issues of concern.

Fact
In 1776, Adam Simth wrote:  The Directors of (joint stock) companies,
however, being the managers rather of other people money than their own, it
cannot well be expected, that they should watch over it with the same anxious
vigilance (as owners)... Negligence and profusion, therefore, must always
prevail, more or less, in the management of the aairs of suc a company
[Smith, 1776, p.700]

Emmanuel Letete

Corporate Finance

Separation of Ownership and Control

Reference: Berle and Means, The Modern Corporation and Private

Property (1932).
Shareholder dispersion creates managerial discretion which could be
abused.
Corporate insiders may not act in the interest of the providers of funds.
How to deal with this problem?
Incentives
Monitoring
But what exactly are the problems we are solving here?

Emmanuel Letete

Corporate Finance

Separation of Ownership and Control: some Issues of

concern.
Moral hazard: We divide these into four categories but in all these cases
managers do not act in the best interest of shareholders (owners). In all
these case the following seem to prevail:
No implication of immoral behavior.
Behavioral risk; hidden action
Owner/manager conict
Manager does not always act in the interest of owners
1. Insucient eort
Insucient internal control of subordinates. Managers
sometimes devote too little time to the work they have
been hired for because the overcommit to other
competing activities (political involvement, investment in
other ventures, or more generally activities not related to
the management of the rm).
Emmanuel Letete

Corporate Finance

Separation of Ownership and Control: some Issues of

concern
Allocation of eort across tasks
Workforce reallocation, supplier switching
2. Over-investment
Pet projects, empire building, acquisitions
3. Entrenchment
Managers making themselves indispensable.
Manipulating performance measures.
Being excessively conservative in good times, excessively
risk-taking in bad times.
Resisting takeovers.
Lobbying against shareholder activism.

Emmanuel Letete

Corporate Finance

Separation of Ownership and Control: some Issues of

concern

4. Self-dealing
Perks: private jets, big oces, etc.
Picking successor
Illegal activities: theft, insider trading, etc.

Emmanuel Letete

Corporate Finance

Dysfunctional corporate Governance

Lack of transparency
Shareholders do not observe compensation details, such as perks
and stock options.
Level of compensation
Tripling of average CEO compensation in the US 1980- 1994, a
further doubling until 2001.
Average CEO/worker income ratio in the US went from 42 in 1982
to 531 in 2000.
CEO/worker compensation ratio among top US rms was at 231 in
2011, down from 381 in 2000, according to the Economic Policy
Institute.
Proponents argue this is a byproduct of more performance based
pay.
Norway: average CEO/worker compensation ratio at 10 in 2005
Smaller companies than the US ones
Report by Randy and Skalpe (2007)
Emmanuel Letete

Corporate Finance

Dysfunctional corporate Governance

Fuzzy links between performance and compensation

Bebchuk and Fried, Pay without Performance (2004).
Compensation in an oil company based on stock price, when
management has little control over the oil price.
Golden parachutes when leaving.
Accounting manipulations
The Enron scandal.
Manipulating stock price, and therefore compensation.
Hiding bad outcomes and therefore protecting against takeovers.

Emmanuel Letete

Corporate Finance

Dealing with these problems

Monetary incentives
Compensation
Salary: xed Bonus: based on accounting data
Stock-based incentives: based on stock-market data
Bonuses vs. stock-holdings (Bonuses provide incentives for
short-term behavior and shares provide incentives for
long-term behavior. The two are complements, not substitutes
The compensation base
Relative performance

Emmanuel Letete

Corporate Finance

Dealing with these problems

Shares vs. stock options

Stock options provide stronger incentives but do not perform well
after a downturn (excessive risk, lack of credibility).
Too low managerial incentives in practice?
In the US in the 1980s, the average CEO kept 3 of shareholder
wealth; later estimate: 2.5%.
But incentives are costly to owners, because of manager risk
aversion.

Emmanuel Letete

Corporate Finance

Dealing with these problems

Implicit incentives
Keeping the job
Firing or takeover following poor performance
Bankruptcy
Career concerns
Explicit vs implicit incentives
Substitutes: Strong implicit incentives lower the need for explicit
incentives but this is dicult to trace empirically.

Emmanuel Letete

Corporate Finance

Dealing with these problems

Monitoring
Boards of directors
Auditors
Large shareholders
Large creditors
Stock brokers
Rating agencies
Active monitoring
Interfering with management in order to increase the value of one's
claims in the rm.
Linked to control rights

Emmanuel Letete

Corporate Finance

Dealing with these problems

Forward looking Examples
large shareholder sitting on the board
resolutions at general assembly
takeover raid
creditor negotiations during nancial distress
Speculative monitoring
Not linked to control rights
Partly backward looking, aiming at measuring value, rather than at
enhancing it.
Example: stock-market analysts, rating agencies
Provides incentives by making rm's stock value more
informative about past performance.

Emmanuel Letete

Corporate Finance

Dealing with these problems

Product-market competition
Relative performance is easier
Exogenous shocks are ltered out

Emmanuel Letete

Corporate Finance

Dealing with these problems

The board of directors

Independence; attention; incentives; conicts
Many dierences across countries.
Active monitoring requires control
Formal control vs real control
Majority owner has formal control.
Minority owners may have real control, convincing other owners of
the need to oppose management.

Emmanuel Letete

Corporate Finance

Dealing with these problems

Ownership structure important for the scope of investor activism

Institutional investors: pension funds, life insurers, mutual funds
Cross-shareholdings
Firms owning shares in each other
Ownership concentration: huge variations across countries
For example: US vs Italy
Ownership stability: again international variation

Emmanuel Letete

Corporate Finance

Dealing with these problems

Limits to active monitoring

Monitoring the monitor: incentive problems inside institutional
investors
Externalities from monitoring
One shareholder's monitoring benets all shareholders
under-provision of monitoring?
Costs of monitoring
Illiquidity
Focus by management on short-term news
Incentives for manipulating accounts

Emmanuel Letete

Corporate Finance

Dealing with these problems

Takeovers
Keep managers on their toes
Make managers act myopically
Takeover bids: tender oer
Takeover defenses
Corporate charter defenses
Making it technically dicult to acquire control
Staggered board
Super-majority rules
Dierential voting rights

Emmanuel Letete

Corporate Finance

Dealing with these problems (Takeovers)

Diluting the raider's equity
Scorched-earth policies: selling out those parts of the rm that the
raider wants
Poison pills
Current shareholders having special rights to purchase additional
shares at a low price in case of a takeover attempt
White knight
An alternative acquirer who is friendly to the current management
Greenmail
Repurchases of stock from the raider, at a premium
Management colluding with the raider, at the expense of other
owners.

Emmanuel Letete

Corporate Finance

Dealing with these problems (Takeovers)

Leveraged buyout (LBO)

Going private, borrowing to nance the share purchase
Management buyout (MBO): an LBO by management

Emmanuel Letete

Corporate Finance

The Role of Debt in Corporate Governance

Debt provides management discipline
Management must make sure there is cash ow available in the
future for paying back debt
Management has less cash available for perks
If the rm does not pay back debt, creditors can force the rm into
bankruptcy
Debt-holders are more conservative then equity holders
Debt-holders suer from bad projects, but get no extra benet from
good projects.
But there are limits to debt
Debt means the rm is less liquid, which is costly.
Internally generated funds are the cheapest source of capital
available for rms.
Bankruptcy is costly.
Emmanuel Letete

Corporate Finance

Summary

Emmanuel Letete

Corporate Finance

Appendix

For Further Reading

The rst main message of your talk in one or two lines.

The second main message of your talk in one or two lines.
Perhaps a third message, but not more than that.

Outlook

What we have not done yet.

Even more stu.
Emmanuel Letete

Corporate Finance

Appendix

For Further Reading

For Further Reading I

A. Author.
Handbook of Everything

Some Press, 1990.

S. Someone.
On this and that.

. 2(1):50100, 2000.

Journal on This and That

Emmanuel Letete

Corporate Finance