FINS 5526

International Corporate Governance

Emma Jincheng Zhang

School of Banking & Finance
jin.zhang@unsw.edu.au

Session 1, 2017
Administration
Lecturer (weeks 7-12)
Emma Zhang (jin.zhang@unsw.edu.au)
Consultation
Wednesday, 3pm - 5pm or by appointment
ASB room 372 (east wing)
Attendance record

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Study ICG: Perspectives from past students
Not considered particularly challenging for most
students;
This course focuses large on how different mechanisms
can be used to increase the effectiveness of a firms
corporate governance and the importance of effective
corporate governance in limiting various forms of risk to
stakeholders and in helping improve firm performance.

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A Quick Review on Corporate Governance

Governance broad view:

The (explicit and implicit) law of the firm
Mechanisms to:
Ensure balance of power and responsibility
Minimize conflict of interest among all stakeholders
Improve overall firm performance
Governance narrow view:
Ways to minimize conflict of interest between agents
and principals (i.e. the agency problems and costs)

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Examples of Agency Problems & Costs
Reduction of managerial effort

Inefficient investment policies

o Over-investment
o Under-investment

Extraction of resources:
o Transfer pricing to associates
o Excessive monetary rewards & perks

Earnings manipulation / creative accounting

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Comparative Systems of Corporate Governance

Anglo-American system: U.S., Canada, UK, etc.

o Market-based system
o Managers vs. small, dispersed shareholders
o External mechanisms (e.g. takeover threat) relatively strong

An alternative system: Germany, Japan, Asia, etc.

o Long-term large investor based system
o Managers, large (controlling) shareholders, and small
shareholders
o External mechanisms relatively weak

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Mechanisms of Corporate Governance
Board of directors (internal)
Executive compensation (internal)
Large shareholders (internal)
Institutional shareholder activism (internal / external)
Banks and other creditors (external / internal)
Takeovers threat & leveraged buyouts (external)
Media and other stakeholders (external)
Regulations, codes and principles, disclosure rules, auditing
rules, etc. (external)

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 FINS 3626
International Corporate Governance

Week 07
Agency Problem, Debt as a Governance
Mechanism and Shareholder Activism
Separation of Ownership and Management
The transition from a small, private business to a large, publicly
listed corporation.

Who are the principals? Who are the agents? Who represents
the principals?
Privately owned firms
Public corporations with dispersed ownership structure
Public or private companies with both large (controlling) and
small (minority) shareholders

Incentive problem (i.e. agency conflict) and entrenchment

problem

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Separation of Ownership and Management:
Origin

Agency conflict Wealth of Nations (1776), Adam Smith

The directors [and executives] of such [joint-stock] companies,

however, being the managers rather of other peoples money than
of their own, it cannot well be expected, that they should watch over
it with the same anxious vigilance with which the partners in a
private copartnery frequently watch over their own. ... . Negligence
and profusion, therefore, must always prevail, more or less, in the
management of the affairs of such a company.

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Separation of Ownership and Management:
Problem

Agency conflict
Problem: managers may act in their own interests rather
than taking care of the shareholders managerial
control and corporate power
This agency problem is most severe with dispersed
ownership structure

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The Agency Conflict

This agency conflict is sometimes referred to as

other peoples money incentive problem.
Level of managerial ownership helps determine the level
of consumption of perquisites
In a 100% owned firm, consumption of $1 worth of
perquisite reduces managers wealth by $1 that
hurts!
If manager owns only 30% of shares, consuming $1
worth of perquisite only reduces the value of his
holding by 30 cents not hurting myself as much

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Types of managerial agency problems
1. Underinvestment problems (perquisite)
Managers may pass up NPV-positive projects and spend the
free cash flow for the personal benefit
2. Overinvestment agency conflicts (empire building)
Managers overinvest free cash flow in projects to increase
the size
3. Time-horizon agency conflicts (myopia)
Managers are concerned with the firms cash flows during
their term
4. Managerial risk-aversion agency conflicts
Risk-averse managers do not invest in positive NPV projects
in order to reduce the risk of the firms cash flows
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 Free cash flows (FCF)
Definition:
The funds generated by the firms existing assets in
excess of those required to finance all available
positive NPV investment opportunities

What would shareholders do with FCF?

FCF should be distributed to shareholders (e.g., dividends) if
1. The market is frictionless (i.e., without tax,
transaction costs, or agency problems)
2. The shareholders hold well-diversified portfolios (i.e.,
the risks can be diversified in the capital market)
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 Underinvestment problem
1. The manager passes up the positive NPV project and uses FCFs
for perquisites
Private jets
Lavish spending on private offices
Lavish compensation, pension, or other form of payments
2. The manager may invest in a project that suits to his/her skills,
rather than more profitable projects
This makes it more costly for shareholders to replace the
manager, because shareholders have to find a manager who has
comparable skill sets
3. These problems are more likely to occur in larger firms (Jensen
1993)
The business/organizational complexity of larger firms makes
it harder for shareholders to monitor the manager
More free cash flows are generated in mature industries
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 Overinvestment problem
1. Empire building motives of the manager
The top management of larger firms enjoys more prestige or more
power in the board rooms
To increase the firms size, the manager may invest in negative NPV
projects
2. FCFs is important for the manager
To increase the firms size, the manager retains earnings excessively
and stack up the FCFs
To finance the investment in external market (e.g., bank loans, bond
or stock), the manager must convince the financiers about the
profitability of investment
3. Diversification discount: the value of conglomerate tends to be less
than the sum of the value of comparable stand-alone firms
The manager with empire building incentives tend to engage in
negative NPV M&As

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 Time horizon agency problem
1. Shareholders tend to be concerned with all future cash flows of the
firm
The current stock price is the discounted value of all future cash
flows
In the frictionless capital market, shareholders want the manager
to invest in positive NPV projects regardless of the investment
horizon
2. Managerial myopia: the manager may only be concerned with the
firms cash flows for their term of employment
The managers who are about to retire or leave the firm tend to
reduce the long-run investment (e.g., R&D investments), in order
to boost the short-run performance before their retirement
(Dechow and Sloan, 1991)
The managers may manipulate the earnings before leaving the
firm, in order to maximize the performance-based compensation
(Healy 1985)
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 Risk aversion agency problem
1. Shareholders tend to hold a well-diversified portfolio
In a complete and frictionless capital market, all investors can
diversify out the idiosyncratic risks
Regardless of their risk-aversion, shareholders do not care
for the idiosyncratic risks that arise from positive NPV
investment
2. Risk-averse managers may be willing to reduce the idiosyncratic
risks
The majority of the managers human capital (i.e., current and
future income) is tied to the firms cash flows
The firm may require the manager to hold a certain fraction
of the firms own shares for the term of employment
To reduce the idiosyncratic risks, the manager may pass up
risky projects, even if the projects have a positive NPV
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The Incentive Problem: Potential Cures?

Increase managerial ownership?

Other mechanisms?
Effective board monitoring
Active actions from powerful investors (e.g. institutional
investors, blockholders, creditors, etc.)
Effective managerial compensation package to reward and
incentivize the managers
Takeover threat and proxy fight
Laws, regulations, rules, etc.
Creditors

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 Debt as a governance mechanism
1. If the firm has outstanding debt, it must pay the proceeds
(interest and principle) to the creditor
The regular payment of interest or principle will reduce the FCFs,
which may be used for lavish perks or over-investment in negative
NPV projects
2. The manager must be disciplined to repay creditors on time
The failure of repayment may lead to liquidation
At the bankruptcy, managers are usually fired and not able to
continue their career as a top manager
3. In the violation of a debt covenant, the creditors intervenes the
management and monitors the managerial decisions
This is particularly relevant to bank loans
In the case of corporate bonds, the dispersed bondholders may
not be able to monitor the firm efficiently
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Example 1. Debt as a governance mechanism
Firm A has a project which requires $100 investment
and generate the following (uncertain) cash flows
next year:
State Revenue Probability
Failure $0 0.5
Success $ 1,000 0.5

Because the firm does not have retained earnings, it

must finance $100 either by issuing equity or debt.
Assume that the interest rate is zero.
Q1. Can the firm finance $100 by issuing equity?
Q2. Can the firm finance $100 by issuing debt?

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Example 1. Debt as a governance mechanism
State Revenue Probability
Failure $0 0.5
Success $ 1,000 0.5

Q1.Yes. As the present value of revenue is $500 (=$1000 x

0.5) > $100 (unless discount rate is ridiculously high)
Q2.Yes. If the firm issues a bond of which face value is $200
(i.e., fixed return to debt holders, even if revenue = $1k), it
can repay the bond only when the firm succeeds in the
project. Thus, the present value of bond is $100 (=$200 x
0.5)

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Example 1. Debt as a governance
mechanism
Firm A has a project which requires $100 investment and generate the
following (uncertain) cash flows next year:
State Revenue Probability
Failure $0 0.5
Success $ 1,000 0.5
Now investors find that, next year, the firm can invest another project
which requires $1000 investment and creates $150 revenue (note that it
has a negative NPV). The manager has a empire building motive and is
willing to invest in any project regardless of the NPV.
Q3. Can the firm finance the new project in the capital market next year
(i.e., not using the return of $1000 from the first project)?
Q4. Can the firm finance $100 with equity now?
Q5. Can the firm finance $100 with short-term debt which matures next
year?
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Example 1. Debt as a governance
mechanism
Q3. No, because the new project has a negative NPV.
Q4. No, if the firm succeeds in the original project, it will
invest in the new project next year. Therefore, the expected
value of the firm is $75 (=$150 x 0.5).
Q5.Yes, the short-term debt must be repaid next year, if the
firm succeeds in the project (i.e., firm must return $200 to
debt holders).

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 Who wants to have a good
governance structure?
1. In example 1, the firm can invest in a positive NPV project only by
issuing debt
If there is a bankruptcy cost, the manager will prefer issuing
equity
The firm cannot guarantee the profitability of equity, because of
the possibility of overinvestment (i.e., a negative NPV project
next year)
By issuing debt, the manager shows its commitment of passing
up the negative NPV project
2. The example shows that it is both the manager and
financiers who are willing to build a good governance
structure
The financiers can benefit from reducing the agency problem
The manager can benefit from lowering the cost of capital, by
alleviating agency problems
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Free-riding problems in
monitoring
1. Free-riding occurs when the one who benefits from other
partys goods or services does not pay for them
2. Free-riding problems may arise in monitoring mechanisms
Institutional investors vs. individual investors
Family/large shareholders vs. dispersed minor
shareholders
Multiple creditors in default
3. Because the managerial monitoring is costly, the
stakeholders have less incentive to monitor the manager
when they ensure that other stakeholders monitor
4. To solve the free riding problem, the stakeholders must
coordinate the monitoring and share the costs

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Example 2. Free riding in
monitoring
Firm B has two outstanding bonds, each of which has a face value $100.
On the default, each bondholder has two options: (i) liquidate the firm
and recovers $80 each, or (ii) extend bonds another year. In option (ii),
the firm will create cash flows which depend on the bondholders
monitoring as follows:
State Revenue Prob. w/o Prob. w/
effort effort
Failure $0 0.5 0
Success $ 300 0.5 1

The manager exerts effort only when the bondholder monitor the
manager by incurring a cost $30.
Q1. If the bondholders make a decision without communicating with each
other, which option would they choose?
Q2. Would the choice of bondholders change if they coordinate the
monitoring?
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Example 2. Free riding in
monitoring
(Solution for Q1.)
Option (i): the bondholder recovers $80.
Option (ii): the bondholders net value (recovery value monitoring cost)
depends on monitoring
a) if a bondholder monitors, its net value is $70 (=$100 - $30)
b) if a bondholder does not monitor but the other bondholder monitors,
its net value is $100
c) if none of the bondholder monitors, the net value to one bondholder is
$50 (=$100 x 0.5)

If a bondholder believes that the other bondholder will monitor, he does not
monitor.
If a bondholder believes that the other bondholder does not monitor, he
liquidates the firm (because $80>$50).
Therefore, bondholders will liquidate the firm, because monitoring is not an
optimal choice in any case.
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Example 2. Free riding in
monitoring
(Solution for Q2.)
Option (i): the bondholder recovers $80.
Option (ii): the bondholders net value (recovery value monitoring cost)
depends on monitoring
a) if a bondholder monitors, its net value is $70 (=$100 - $30)
b) if a bondholder does not monitor but the other bondholder monitors,
its net value is $100
c) if none of the bondholder monitors, the net value is $50 (=$100 x 0.5)

If two bondholders can communicate, they will extend the bond by sharing
the monitoring cost (i.e., one of them monitors and receives $15 from the
other).
In doing so, each of them obtain the net value $85 (= $100 - $15).

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Contingent monitoring by
bondholders
1. Creditors interrupt the management and monitor the manager,
if the firm fails to repay
2. Free riding problem on monitoring is more likely to occur in
the default of corporate bonds than syndicated bank loans
Coordination of monitoring is easier for the syndicated
bank loans: corporate bondholders are very dispersed, while
syndicated bank loans are managed by a lead bank
Banks are more specialized in monitoring
3. Syndicated bank loans have more diverse and stricter
covenants
Default occurs more frequently in syndicated bank loans
Syndicated loans are more likely to be renegotiated

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The Roles of Shareholders
Provide risk capital
Shareholders expect returns (dividends, capital gains)
Elect members of the board
The board of directors should represent all shareholders and
act in their best interests

Shareholder activism:
When things are not going too well help bring about
positive changes!!

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 Shareholder Activism (Individuals and/or
Institutions)
Shareholder activism
Collective effort by shareholders to take the role of monitoring
management into their own hands
Institutional activism
Activism effort by large institutions, especially financial institutions
such as banks and funds
Two forms of activism:
Private: Behind-closed-doors discussion/consultation with
managers and the board of directors
Public: Proxy contests

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An Example: Carnegie vs Qantas

Carnegie group vs. Qantas

In late 2012, a consortium led by Mark Carnegie (including Geoff
Dixon, Gerry Harvey, etc.) bought a small equity stake in Qantas.
They were dissatisfied with the strategic direction of Qantas, and
the leadership of Allen Joyce.
The unsuccessful private form of activism
The consortium held meetings with institutional investors to
sound out support for an alternative strategy for the airline.
However, the move didnt gain support from enough Qantas
investors, including institutions;
The consortium sold their Qantas shares in early 2013.

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Proxy Contests

The fighters:
Dissident group of shareholders
Management team
The weapon:
Shareholders votes (or proxies)
The place:
Annual General Meetings (AGMs) or Extraordinary
General Meetings (EGMs)
The share price reaction at announcement:
Price jumps up because the value of voting right
increases, and also some expected benefits if wins

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Annual General Meetings (AGMs)

Some typical Items of Business to be voted on at the

AGMs:
Election or re-election of directors
Executive compensation (Say on Pay)
Important asset purchases or sales
Important capital raising activities
Capital restructuring
Operational restructuring
Proposed mergers

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The Proxy Voting System

Shareholders who cannot physically vote at the AGMs

can authorize proxies to vote on their behalf
Proxies are normally directors;
When no proxies are appointed, the chairman becomes the
proxy;
In proxy fights, dissidents shareholders can try to convince other
shareholders to appoint them as proxies.
Directed proxy
Authorized proxies must vote as instructed
Undirected proxy
Shareholders are deemed to support board recommendations

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Example: GoldmanSachs 2010 Proxy

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Example: GoldmanSachs 2010 Proxy (Cont.)

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Example: GoldmanSachs 2010 Proxy (Cont.)

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The Proxy Voting System

Management has advantages over dissidents, because:

Directors are often on the managers side, and shareholders
often delegate directors to be their proxies;
Many shareholders abstain from voting;
Managers may have closer relation with large or institutional
investors;
Managers can use the firms resources to run their
campaign;
Dissidents do not have full access to shareholder registry.

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Proxy Contests: Benefits and Costs

Advantages:
Lower costs & quicker process compared to hostile
takeovers
On average, positive stock price effect
Brings about some sort of changes

Disadvantages:
Less effective (in challenging the incumbent managers)
compared to hostile takeovers
Often subject to the free-rider problem

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What Promotes / Prevents Shareholder
Activism?
Protection of shareholder rights
Specifically, the rights to vote
At the country level: Company Law
Efficiency of the judicial system
Absence of political corruption
At the firm level: Companies constitutions and bylaws
Specifying issues voted at AGMs and EGMs
Provisions regarding voting process to block shareholders, such as:
Supermajority requirement
Limitation on the use of voters written consent (EGMs)
Percentage required to call EGMs

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Example: GoldmanSachs 2010 Proxy (Cont.)

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Shareholder Activism is on the Rise

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Shareholder Activism is on the Rise
Past:
Shareholder turnout at AGMs in Australia: barely 10%
Domestic funds hold 50% of shares but only exercise 30% of the
votes Joe Hockey, former Australian Fin Ser Minister.
There appear to be little demand for reporting corporate governance
issues AMP (response to IFSA survey)
Present:
7 out of 10 shareholders plan to make a stand at AGMs
Institutions cast their vote on 67% of resolutions latest IFSA survey

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Targets of Proxy Contests

Source: Latham & Watkins LLP 46

Common Shareholder Activism Tactics

Source: Latham & Watkins LLP 47

Example: Icahn vs. Yahoo!

Feb 1st, 2008: Microsofts takeover offer of Yahoo!, which

was rejected by Yahoo!
May 3rd, 2008: Microsoft withdrew its offer.
May 13th, 2008: Carl Icahn purchased around 50mil shares
of Yahoo.
May 15th, 2008: Icahn confirmed that he would be
commencing a proxy fight.

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Icahns Letter to Yahoo!
It is clear to me that the board of directors of Yahoo has
acted irrationally and lost the faith of shareholders and
Microsoft;
I have formed a 10-person slate [of directors] which will
stand for election against the current board;
I have sought antitrust clearance from the Federal Trade
Commission to acquire up to approximately $2.5 billion
worth of Yahoo stock;
I sincerely hope you heed the wishes of your shareholders
and move expeditiously to negotiate a merger with
Microsoft, thereby making a proxy fight unnecessary.

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Example: Icahn vs. Yahoo!

July 21st, 2008: Icahn and Yahoo! reached an agreement

and Icahn dropped his proxy fight.

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Example: Lew vs. Coles Myer

Solomon Lews interest in CML

Through Premier Investments and private interests
Before the fight, Premier increased ownership to 6%
Lews proposals:
Keep his board seat
Return of discount card
Tactics
Rent-a-vote strategy aimed at institutional shareholders

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Stylized Example: Rent-a-vote

The dissident, e.g. Lew, buys the share + put option, before
the proxy contest, at a price of $11. The put option can be an
will be exercised right after the contest, at a price of $10;

Shareholders who lend their voting shares to the dissident:

receive $1 (=11-10) per share;

The dissident: pay $1 for the voting right per share.

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Example: Lew vs. Coles Myer

The discount-card scheme bought over 500,000

retail shareholders;
Lew rented votes of 4% of CMLs equity; ultimately,
these votes were rented not from institutions but
individuals;
In fact, near total institutional opposition;
Lew got support from 268 million votes;
Lew lost the fight by the margin of 160 million votes.

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Institutional Shareholders

Include:
Commercial banks and investment banks
Insurance companies
Pension (superannuation) funds
Mutual funds (managed funds, unit trusts)
Hedge funds, Private Equity funds, etc.

Important: substantial power, monitoring capabilities,

potential inside information;
Thus, institutional investors are naturally expected to be
active in corporate governance.

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Recent Trends in Institutional Activism

In the past, institutions have been very inactive in

monitoring / disciplining managers:
Regulatory restrictions on the size of individual
shareholdings of fund managers;
Concentrated ownership of company insiders and the use of
dual-class shares among listed firms;
Different fund managers styles and the free-rider problem;
Institutions may view voting as the responsibility and right of
their clients rather than of themselves;
Business relationships with managers;
Agents watching agents problem.

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Recent Trends in Institutional Activism

Activist institutions are now more common:

Increased size of managed assets
Regulatory changes made the proxy voting process fairer and
transparent to all parties
Communication among shareholders has been improved
Legal and regulatory duties of institutions
Institutional activism has been associated with:
CEO turnover and removal of directors
Firm performance turn-around
Rejection of anti-takeover defenses

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Recent Trends in Institutional Activism

Corporate governance funds:

A fund targeting long-term capital gain from shareholder
activism;
Select companies with poor performance due to governance
problems;
Acquire large equity stakes to enforce changes;
Changes initiated through private pressuring or proxy
contests;
Realize long-term gain from governance changes;
Different to contrarian (buy low sell high) strategy.

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Institutional Shareholder Activism

Examples of activist institutions

US: CalPERS, TIAA-CREF, etc.
UK: HERMES, etc.
Australia:
Australian Shareholders Association (ASA)
Institutional Shareholders Services (RiskMetrics Australia)

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