©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 1 - - - - - -...

©2001 Prentice Hall Takeovers, Restructuring, and Corporate

Governance, 3/e Weston - 1

- - - - - - - - Chapter 20 - - - - - - - -

Corporate Governance and Performance



Corporate Governance Systems in the United States

• Diffuse stock ownership– Limited liability public corporation– Diffuse ownership of voting equity shares– Large number of individual share owners



• Requires little direct monitoring of individual firms by investors– Limited liability of investors– Diversification allows investors to ignore

idiosyncratic risks of individual companies– Equity ownership shares actively traded

• Commercial banks and insurance companies limited in their ability to hold large equity positions in individual companies



• Contractual theory of the firm

– Firm as network of actual and implicit contracts • Contracts specify roles of stakeholders and

define their rights, obligations, and payoffs• Potential conflicts

– Contracts unable to envisage many changes in conditions that develop

– Participants may have personal goals

– Separation of ownership and control• Operations of firm are conducted and controlled

by managers without major stock ownerships• Conflicts of interest arise between owners and

managers



– Jensen and Meckling (1976)• Agency problem — divergence of interests

between owners (the principal) and management (their agent)

• Fractional firm ownership by managers can lead managers to work less and to consume excessive perquisites

• Additional monitoring expenditures (agency costs) are required

– Auditing systems– Bonding assurances– Organization systems



• Divergent interests of stakeholders– Business firms must recognize wide range

of expectations of diverse stakeholders– Business firms must recognize external

influences — job safety, product safety, environmental impacts

– Business firms must recognize wide range of stakeholders and external influences to achieve long-run value maximization



Internal Control Mechanisms

• Shareholders elect board of directors to represent their interests

• Problems of how all stakeholders can obtain representation of their views and interests have not been resolved

• Public expectations look to board of directors to balance interests of all stakeholders



• Campbell, Gillan, and Niden (1999)– Analyzed how shareholders used proxy mechanism

in 1997 proxy season– Shareholder-proposal rules (Rule 14a-8) allow

shareholders to include proposal and 500-word supporting statement in proxy materials

– Sample of 287 social policy proposals and 582 corporate governance proposals at 394 companies

– 43.3% of all proposals were considered for vote• Corporate governance proposals — 49.2% were voted on

and 35.2% were either omitted or withdrawn• Social policy proposals — 31.4% were voted on and 61.6%

were either omitted or withdrawn

– Rule 14a-8 remains an important avenue for shareholders



Role of the Board of Directors

• Views of role of monitoring board– Pro: In theory, monitoring by board of

directors can deal with problems of corporate governance

– Con: Boards have been ineffective• Board fails to recognize problems of firm• Board does not stand up to top officers• External control devices such as hostile

takeovers have multiplied because of failure of boards



• Composition of the board– Role of outside directors

• Outside directors — directors who neither work for the corporation nor have extensive dealings with company

• Outside directors play larger role in monitoring management than inside directors

– Fama (1980)• Outside directors enhance viability of board in

achieving low-cost internal transfers of control• Lower probability of collusion with top

management– Fama and Jensen (1983a) — outside directors have

incentives to protect and develop reputation as experts in decision control



– Weisbach (1988)• Tested hypothesis that inside and outside

directors behave differently in monitoring top management

• Outsider-dominated boards more likely to remove CEO

• Replacement of CEO– Statistically significant inverse relation between firm's

market-adjusted share performance in a year and likelihood of subsequent change in CEO

– For outsider-dominated boards, responsiveness of removal decision to stock market performance is three times larger than for other board types

– Replacement decision takes place relatively quickly



– Rosenstein and Wyatt (1990) — CAR for total sample was significantly positive when company appointed outside directors

– Borokhovich, Parrino, and Trapani (1996)• Positive relation between proportion of outside

directors and likelihood that outsider is appointed CEO

• Market views appointment of outsider to CEO position more favorably than appointment of insider



• Compensation of board members– Well-structured compensation systems may

motivate directors• Director stock ownership better aligns director

interests with stockholders– Stock ownership requirements for directors and/or

payment of part or all of directors' annual retainer in stock and stock options

– Finance directors' retirements with stock

• Studies find directors of top-performing companies hold greater number of shares than do counterparts at poor-performing firms

– Critics argue that compensation should not be motivating factor



• Evaluating a board of directors– Business Week (11/25/96)

• Rated boards by how close they came to meeting these recommendations:

– Evaluate CEO performance annually– Link CEO pay to clear performance criteria– Review and evaluate strategic and operating plans– Require significant stock ownership and

compensate directors in stock– No more than three insiders– Require election each year and mandatory

retirement at 70



– Key committees should be composed of outside directors

– Limits on number of boards and ban on interlocking directorships

– Disqualify (from board) anyone receiving fees from company

• Some pension funds and mutual funds judge boards by stock market performance of their companies — a "blinkered view"

– Millstein and MacAvoy (1998)• Better board rating (based on either board

independence or performance) associated with higher spread of return on invested capital (ROIC) over cost of capital (WACC)



Ownership Concentration

• Equity ownership by managers must balance– Convergence or alignment of interests– Entrenchment considerations —

managerial ownership and control of voting rights may allow pursuit of self-interest



• Ownership and performance– Stulz (1988)

• Model in which at low levels of management ownership, increased equity holdings improve convergence — enhance firm value

• At higher levels of insider ownership, managerial entrenchment prevents takeovers — decrease firm value



– Morck, Schleifer, and Vishny (MSV) (1988)• Study based on 1980 data• Performance (measured by q-ratio) related to

management or insider ownership percentages– Ownership concentration increased from 0 to 5%

• Performance improved • Alignment-of-interest effect • Direction of causality may be reversed — high

performance firms more likely to give managers stock bonuses

• High performance firms may have substantial intangible assets that require greater ownership concentrations to induce proper use of these assets



– Ownership concentration in range 5% to 25%• Performance deteriorated• Management entrenchment dampens

performance– Ownership concentration above 25%

• Performance improved but slowly• Incremental entrenchment effects attenuated



– McConnell and Servaes (MS) (1990)• Replicate MSV study using 1976 and 1986 data

– For 1976, relationship between ownership concentration and performance relatively flat with moderate convergence of interest effect up to 50%, after which curve flattens and then declines moderately

– For 1986, relationship curve rises relatively sharply to 40%, after which it is relatively flat to 50% followed by sharp decline

• Leverage, institutional ownership, R&D expenditures, and advertising expenditures do not change initial findings



– Cho (1998)• Replicates MSV patterns using ordinary least

square regressions and 1991 data• Tests for endogenous ownership structure • Finds that corporate value affects ownership

structure, but not reverse

– Bristow (1998)• Sample of consistently derived insider holdings

on 4,000 firms during 1986-95• Relationship between management ownership

and performance varies for each of the ten years



• Economic variables influence ownership-performance relationship

– Relative growth rates of industries– Differences in demand-supply relationships among

industries– Relative value change patterns among industries and

firms within them– Stock price movements

• Interpretations of diverse data patterns– May reflect economic identification problem

discussed by Cho – True relationship may be Demsetz-Lehn theory of no

relationship between ownership level and performance



– Holderness, Kroszner, and Sheehan (1999)• Percentage of managerial equity ownership

– Mean increased from 12.9% in 1935 to 21.1% in 1995– Median increased from 6.5% in 1935 to 14.4% in 1995

• Doubling of managerial ownership may imply improvement in corporate governance in U.S.



• Managerial ownership and bond returns — Bagnani, Milonas, Saunders, and Travlos (1994)– No relation between bond returns and

managerial ownership below 5%– Positive relation for managerial ownership

between 5% and 25%• Increased incentives for managers to act in

shareholders' interest, taking risks that are potentially harmful to bondholders

• Rational bondholders required higher returns



– Weak negative relation for ownership above 25%• Managers become more risk averse• Managers have high stake in firm — greater

incentives to protect their private benefits and objectives

• Managers' interest more aligned with bondholders — lower bond premia



• Financial policy and ownership concentration– Share repurchases financed by debt

• Insider group does not tender its shares in repurchases — percentage equity shares increased

• Increased convergence of interest effect

– Incentive effects of high management ownership percentages performed positive role in LBOs and MBOs



– Safieddine and Titman (1999)• Sample of 573 firms that successfully resisted

takeover attempts during 1982-1991• Effects on leverage

– Increased leverage is one form of defensive strategy– In 207 firms, median leverage ratio increased from

60% to 71.5%

• Corporate restructuring activity– Turnover of top management during three-year window

• 30% for low leverage increasing group • 37% for higher leverage increasing firms

– Turnover of top management after takeover attempts• 44% replaced in hostile takeover attempts• 29% replaced in friendly takeover attempts



• Operating performance improves and long-run post-termination performance of leverage-increasing targets superior to benchmark

– Returns grow by about 55% after five years– Level of returns same as what would have been

realized by accepting takeover offer

• Manager's behavior of leverage-increasing target firms consistent with long-term interest of their shareholders

– Strong long-term abnormal stock price performance despite initial drop at takeover termination announcement

– Associated productivity improvements



– Amihud, Lev, and Travlos (1990)• Sample of firms that made cash acquisitions

of over $10 million of other firms during 1981-1983

• Cash acquisitions are associated with significantly larger insider ownership levels than stock financed acquisitions



Executive Compensation

• Conflict of interest between owners and managers reduced if executive compensation plans more tightly related pay to performance



• Executive compensation and changes in value of firm– Jensen and Murphy (1990)

• Executive pay changes only $3 for $1,000 change in firm wealth — elasticity of 0.3%

• Low elasticity indicates executive pay is not closely linked to performance

• But low elasticity partially explained by large value of firm in relation to executive compensation



– Haubrich (1994) — derived Jensen-Murphy results using principal-agent theory models

– Schleifer and Vishny (1995) — Jensen-Murphy relationship would generate large swings in executive wealth and would require considerable risk tolerance for executives



• Executive compensation and firm's corporate governance — Core, Holthausen, and Larcker (1999)– Sample of 495 observations for 205 publicly

traded U.S. firms during 1982-1984– Board of director characteristics and ownership

structure significantly related to CEO compensation• CEO compensation higher

– CEO was also board chair– Board was larger– Greater percentage of outside directors appointed by CEO– More outside directors considered 'gray' – Outside directors older and served on more than three other

boards



• CEO compensation lower– Greater percentage of inside directors in board– Lower CEO's ownership stake– Existence of non-CEO internal board members or external

blockholders who owned at least 5% of equity

– Significant negative relationship between compensation predicted by board and ownership variables and subsequent firm operating and market performance• Board and ownership variables are proxies for

effectiveness of firm's governance structure• CEOs of firms with greater agency problems were

able to obtain higher compensation• Firms with greater agency problems perform worse



• Executive compensation and performance measures– Criticism that compensation had been based

on accounting measures rather than stock market-based performance measures

– Rappaport (1986)• Early executive compensation performance plans

were market based• In 1970s, performance measures for granting

options shifted to accounting-based measures• In recent years, performance is moving to market-

based measures



• Other proposals for improved pay-performance policies– Limit base salaries of top executives– Bonus and stock option plans based on

stock appreciation– Stock appreciation benchmarks should

consider• Close competitors• Wider peer group• Broader stock market indexes



– Stock options based on premium of 10-20% over current market and should not be repriced

– Company loan programs should enable top executives to buy substantial amounts of firm's stock

– Directors should be paid mainly in stock with minimum specified holding periods



Outside Control Mechanisms

• Stock prices and top management changes– Warner, Watts, and Wruck (1988)

• Poor stock price performance likely to result in increased rate of management turnover

• Evidence of several internal control mechanisms — monitoring by large blockholders, competition from other managers, discipline by board



– Denis and Denis (1995)• Announcement of changes in management

– Forced resignations: Positive 1.5% (significant)– Normal retirements: Insignificant effects

• Forced top management changes – Preceded by significantly large operating

performance declines and followed by significant improvements

– Associated with significant downsizing measured by declines in employment, capital expenditures, total assets

– Improvements did not result from effective board monitoring



– 13% of 853 sample were forced changes• Two-thirds of forced resignations associated with

blockholder pressure, financial distress, shareholder lawsuits, and takeover attempts

• 56% of firms with forced changes became target of corporate control activity

– Internal control mechanisms were inadequate; required pressure from external corporate control markets



– Role of stock market• Schleifer and Vishny (1997) survey does not

develop potential role of stock market and security price movements in disciplining managers

• Security price movements provide scorecard measuring management performance

• Bad scores on stock market increase likelihood of managerial turnover



• Public pension funds– Public pension funds have ability and size to

become significant factors in corporate governance• California Public Employees' Retirement System

(CALPERS) publicly announced names of companies that failed to negotiate adoption of corporate reforms

• World’s largest pension plan, TIAA-CREF, encourages companies to have independent, diverse boards



– Carleton, Nelson, and Weisbach (1998)• Described negotiation process between TIAA-

CREF and target firms on governance issues• All firms agreed to institute confidential voting• Most firms contacted added women or

minorities to board• Most firms that were asked to limit use of blank

check preferred stock as antitakeover defense complied



– Wahal (1996)• Nine activist pension funds in period 1987-1993• Activist proposals shifted from takeover-related

proxy proposals in late 1980s to governance-related proposals in 1990s

– Takeover-related proxy proposals — poison pills, greenmail, antitakeover provisions

– Governance-related targeting — golden parachutes, board composition, compensation



• Abnormal returns– Zero average abnormal returns for shareholder

proposals – Small positive abnormal returns for attempts to

influence target firms in using shareholder proposals (nonproxy targeting)

– No significant long-term improvement in either stock price movements or accounting measures in post-targeting period



– Strickland, Wiles, and Zenner (1996)• Studied United Shareholders Association (USA)

from 1986 to 1993• USA developed a Target 50 list of firms• USA successfully negotiated corporate

governance changes in 53 proposals before inclusion in proxy statements

• Abnormal return to target firm = 0.9% at announcement of negotiated agreements — wealth increase of $1.3 billion

• USA effective when target firm was poor performer with high institutional ownership



Multiple Control Mechanisms(Agrawal and Knoeber, 1996)

• Sample of 400 largest firms • Consider seven control mechanisms

– Insider shareholdings– Outside representation on board– Debt policy– Activity in corporate control market



– Institutional shareholdings– Shareholdings of large blockholders– Managerial labor market

• Firm performance measured by Tobin's q• Results

– Considering influence of each control mechanism separately — first four control mechanisms statistically related to firm performance

– Considering all mechanisms together, but not within simultaneous equation system — influence of insider shareholdings drops out



– Considering all mechanisms together and using simultaneous equation system — only negative effect on firm performance from outside representation remains

– Concluded that control mechanisms chosen optimally except for use of outsiders on boards (most other studies find positive benefits from use of outsiders)



Proxy Contests

• Background– Definition: Attempts by dissident groups of

shareholders to obtain representation on board of directors

– Success of proxy contests• Most fail to get majority representation• Better measure of success: Whether dissident

group gains at least two members on board — one to make motion, another to second it



– Proxy reform rules• Under old rules: Any shareholder who wanted to

communicate with more than ten other shareholders required to submit comments for SEC approval prior to circulation

• Under new rules of October 1992: Ease requirements for shareholders not seeking control to communicate with one another

– Focus of empirical studies• Disciplinary value of proxy contests in managerial

labor market• Relationship between proxy contests and other

forms of takeover activity• Value of vote



• Wealth effects — Earlier studies– Dodd and Warner (1983)

• 96 proxy contests over period 1962-1978• Dissidents won majority on board in only 20%

of cases• Returns to target shareholder positive and

significant = 6.2% from 39 days before announcement through outcome

• Hypothesis to explain positive returns– Even minority board representation allows dissident

group to have positive impact on corporate policy– Challenge alone (even if no seats change hands)

may lead incumbents to improve policy



• No evidence of stock price declines when contests fail

– Possibilities of increased efficiency exposed during contests

– Negative abnormal returns at contest outcome announcement for contests in which dissidents failed to win any seat at all (-1.4%), not large enough or significant to offset earlier gains



• Information leakage– Inevitable due to mechanics of waging proxy contest– Significant abnormal returns of 11.9% over period

starting 60 days before announcement through announcement itself

– Returns not attributable to merger activity — results are similar regardless of whether or not dissident group included another firm

– No unexpectedly higher earnings in preannouncement period to explain runup

– Conclude proxy contest is source of positive returns



– DeAngelo and DeAngelo (1989)• 60 proxy contests during 1978-1985• Dissidents successful in one-third of contests• Returns to shareholders

– 40 days before contest through outcome announcement = 6.02% significant

– 40 days preceding any public indication of dissident activity = 18.76% significant

– Gains not dependent on contest outcome



• Negative returns at outcome when dissidents won no seats

– Two-day outcome announcement period = -5.45%– When incumbents prevailed in shareholder vote —

insignificant negative return (-1.73%)– When dissidents defeated by other means —

significant negative return (-7.19%); include:• Expenditure of corporate assets to buy off

dissidents• White knight acquisition of target• Court approval of validity of incumbent's defense

causing dissidents to withdraw



• Strong link between proxy contests and takeover activity

– Follow-up on targets for three years after contest• Only 20% remained independent public firms

under same management• In 20 of 39 firms in which dissidents failed to win

majority, there were 38 resignations of CEO, president, or chairman of board

• 25% (15 cases) were sold or liquidated– Most of the gains to proxy contest activity are closely

related to merger and acquisition activity• Initial precontest gains (about 20%) reflected

increased likelihood of eventual sale of firm at premium after proxy contest



– Split sample results• Firms eventually sold/liquidated — abnormal

returns over full contest period = 15.16%• Firms not sold/liquidated — less significant

abnormal return = 2.9%• Initial runup for both classes revised as more

information becomes available about likelihood of sale

– Goal of proxy contests — get representation on board to persuade rest of board to sell or liquidate



– Sridharan and Reinganum (1995)• 79 hostile tender offers and 38 proxy contests• Proxy contest more likely to take place

– Target firm performance is relatively poor as measured by return on assets and stock returns

– Managerial inefficiency– When shareholdings of management are high

• Tender offers more likely when – Firm fails to pursue new and profitable investment

opportunities– Tender offer targets tend to be less leveraged than

firms experiencing proxy fights



• Wealth effects — Later studies– Borstadt and Zwirlein (1992)

• 142 firms involved in proxy contests during 1962-1986

• Sample divided into two groups– Full-control sample — Dissident success rate = 42%– Partial-control sample — Dissident success rate = 60%

• Turnover rate of top management after proxy contest higher than average

• Positive abnormal return of 11.4% (significant) during proxy contest period (60 days prior to announcement of contest through contest resolution announcement)



– Ikenberry and Lakonishok (IL) (1993)• 97 election contests during period 1968-1987• Test hypothesis that proxy contest represented

referendum on management's ability to operate firm and can act as disciplinary mechanism

– Contest targets underperformed control firms by 39.3% (significant) over five-year period prior to announcement of election contest

– Proxy contest appears to be stimulated by poor performance

• Return to shareholders– For period from month -60 to month -5 relative to

announcement of contest, CAR of proxy contest targets = -34.4% (significant)



– Incumbent board members retain all their seats: CAR not significantly different from zero for five-year period following contest

– Dissidents gain at least one board seat: CAR from month +3 to +24 = -32.4% (significant)

– Dissidents gain control of board: CAR from month +3 to +24 = -48% (significant); negative return due to

• Overoptimistic expectations of improved performance

• Dissidents' discovery that company faced more serious problems than anticipated

• Negative returns different from positive returns found in earlier studies



– Mulherin and Poulsen (1998)• Sample of 270 proxy contests for board seats

during 1979-1994• Returns to shareholders

– Day 0 = date of contest initiation; Day R = contest resolution date

– Initiation period [-20,+5]; CAR = +8.04% (significant)– Post-initiation period [+6,R]; CAR = -2.82% (not

significant)– Full-contest period [-20,R]; CAR = +5.35%

(significant)– Post-contest period of one year following contest

resolution; CAR = -3.43% (borderline significant)



• Results contradict substantial decline in post-contest period reported by IL

– Performance measurements sensitive to survivorship bias arising from minimum data requirements

– IL's requirement that firm be listed in Compustat in period around contest led to downward bias in estimated wealth changes

– Compustat requirement excluded sizeable number of firms that were acquired in period surrounding proxy contest



• Management turnover and shareholder returns– Management turnover should be integral part of

interpretations of changes in shareholders wealth in post-contest period

– IL reported wealth decline, whether dissidents attained seats or not, but failed to observe that wealth changes following proxy contests were positive when there was management turnover



The M&A Market for Control• Market for corporate control most widely

recognized form of external pressure• Empirical metrics demonstrate M&As do

impact business firms– Mitchell and Mulherin (1996)

• 1,064 firms listed in Value Line Investment Survey at end of 1981

• 57% of these firms had been either a takeover target or had engaged in defensive asset restructuring



– Schwert (1996)• Comment's M&A proprietary database of all

NYSE- and AMEX-listed target firms from 1975-1991

• 1,814 target firms, a substantial percentage of total listed firms

• MBOs represented 11.4% of main sample of 1,523 firms

– Mergerstat Review• Many M&A announcements in recent years

– 3,510 in 1995– 9,278 in 1999



• M&A market is major source of external control mechanisms — indicates at least some degree of failure of internal control mechanisms



Alternative Governance Systems

• Summary of U.S. governance system– Managerial stock ownership has increased

over time– Large and small shareholders protected by

well-developed systems of laws, court decisions, and financial market that facilitate • Efficient transaction of securities• Protect minority rights• Enable shareholders to sue directors for violations

of fiduciary duty



– Changes in stock market prices quickly penalize companies for poor performance and reward them for excellence

– Vigilant stock market may cause managers to emphasize short-term results

– Bankruptcy laws are highly protective of managers; after entering into bankruptcy• Management remains in possession of company• Provision is made for automatic stay• Interest continues to accrue only on fully secured

debt• New financing is facilitated since it has priority

status



• Shleifer and Vishny (1997)– German governance system

• Creditors have stronger rights than in U.S.• Shareholder rights are weaker than in U.S.• Large shareholders, often major banks and

financial groups, exercise control over large firms as permanent investors and lenders

• Small investors have virtually no participation in stock market



– Japanese governance system• Degree of protection to shareholder and

creditor rights fall between U.S. and Germany• Powerful banks and long-term shareholders in

Japan not as powerful as in Germany; anecdotal evidence questions this conclusion

– Japanese companies have financed in U.S. during earlier periods of time when Japan supposedly had lower financing costs than rest of world

– Japanese firms sought to avoid strong controls that came with financing from Japanese banks



• Industrial firms own shares in one another and groups of firms become tied together by cross-shareholdings (Kaplan, 1994)

• Governance system has facilitated participation by small investors in stock market



– U.S., Germany, and Japan have in common well-articulated set of rules that provide effective legal protection for at "least some type of investors" and are enforced by courts and regulatory agencies



– Governance systems in other countries• Italy

– Predominantly family controlled– Difficulty raising outside funds– Investment mainly financed internally– Bank financing mainly by state banks for state firms

• Rest of world– Similar to Italy– Absence of system of laws, regulations, and courts

to protect minority investors and creditors– Rules of game are deficient– Large firms, mostly family controlled, rely on internal

financing, or obtain help from government controlled banks



• Economist (1994) – German and Japanese corporate

governance differ from U.S.• Stronger role of banks and financial groups• In theory, large ownership position of owners-

lenders lead to effective monitoring

– Critique of German and Japanese corporate governance model• Banks have not monitored closely firms to which

they provide both equity and debt capital; banks become active only when client firms experience difficulties



• German and Japanese models appear good only because of earlier favorable economic environment — all parties have same long-term interests and goals

• As economic growth slows, conflicts of interest among different stakeholders arise

• Supervisory boards (in Germany particularly) did not seem to meet often enough and acted slowly

– Incompetent managers permitted to complete standard 5-year contract

– Chairman of board often leader of executive board– Supervisory boards not adequately informed

• Large banking corporations have their own governance problems



• Conclusion: American-British systems of shareholder control works better– Market-based– Increased activism of pension funds– Active market for corporate control in form

of M&A activity– Increased M&A activity in Japan and

Germany after 1999• Consistent with deficiencies of internal control

mechanisms• Outside market for corporate control was

needed to improve corporate performance

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 1 - - - - - -...

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