A Survey of Corporate Governance
Authors: Shelifer, Vishny
By Maia
This article surveys research on corporate governance, with special attention to the importance of legal protection of investors and of ownership concentration in corporate governance systems around the world.
Corporate governance- the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment. USA, Germany, Japan, UK have some of the best corporate systems in the world. In less developed countries, corporate government mechanisms are almost nonexistent.
I. The Agency Problem
The agency problem is an essential element of the so-called contractual view of the firm: The essence of this problem is separation of management and finance (ownership and control).
I.A) Contracts
Ideally, managers and owners have to sign a complete contract that defines managers’ actions in all states of the world, and how profits are allocated. But as future is totally ambiguous and unpredictable these contracts are not possible. Therefore the contract should define how the control rights are allocated. As a result manager gets substantial control rights and therefore the control of allocation resources and financiers usually are not informed enough to make decisions.
In practice the situation is even more complicated,
1) As the legal institutions will intervene only in the major violations.
2) When there are many small investors they are really poorly informed even to exercise their rights, and of course to influence something.
Conclusion: The effective control of managers is substantially higher than it would be if courts and small investors would be actively participating in the company’s life.
I.B) Management Discretion
If managers have substantial control of the resource allocation, they can expropriate investors. The least cost is when manager gets higher salary, company airplane etc. The higher costs are when manager is expanding the firm in his interests – pet projects etc. Another issue is that sometimes managers are able to stay at the position even if they have failed to run it competently in the long run. If manager resists going out it may be the costliest agency problem. One more problem is that even if the manager cannot expropriate the money right now, he can not to return the money to managers but undertake the project with negative NPV but yielding high benefit to the manager afterwards. To avoid this investors have to “bribe” the manager – pay him to convince to accept hostile takeover – this is called “golden parachute”. Argument against it is that several investors have to gather together, to agree up on that, however it is not strong enough as manager can discuss his “bribe” with small BoD.
However we rarely observe such cases in the real life because undertaking of such project would violate managers’ “duty to loyalty” to the shareholders.
Conclusion: When contract is incomplete it gives to the manager control rights, and it gives him opportunity to make investments which will provide him personal benefits, which are lower than the costs for investors. Moreover the managers’ duty makes it difficult to contract these inefficiency distributions.
I.C) Incentive Contracts
The better solution would be to make and incentive contract for the manager, to align managers interests with the investors’ ones. There could be cases if Private Benefits of Control would outweigh the incentive contract, but this would be really rare if the remuneration is substantial. Incentive contract can take variety of forms: options, share of ownership, threat of dismissal. Nowadays we can see that incentive contracts are “too generous” and thus inefficient.
However these incentive contracts give to the managers enourmous possibilities for self-dealing. They can negotiate such contracts when they are sure about stock price to rise, or manipulate accountancy figures.
Conclusion: incentive contracts do not solve the agency problem. However we cannot state that managers do not care about the performance at all.
I.D) Agency costs
There is lots of evidence from the ‘’event” studies that managers do the actions not in the interests of the shareholders. The idea is that if manager makes an announcement after which stock prices fall – this action serves in own interests.
Managers often will choose to reinvest money in some pet projects rather than pay out to the investors.
II. Financing without Governance
Here authors provide 2 explanations why investors are investing their money in firms, from which they can basically get nothing.
1) Relying on the reputation of the managers and firms
2) Investors’ optimism
1) Managers are likely to repay to the investors as they would like to stay in the financial markets in the long run, and be able to raise funds in the future. Therefore firms are paying dividends. The same case is with the debtors – if firm repays it short term debts – then it is building its reputation.
2) The investors become excited about the company and therefore they are not thinking about getting their money back – they focus only at the short term share appreciation. And this is how Ponzi schemes are working (pyramids).
3) Conclusion: Despite the fact that these 2 explanations have some explanatory power, it is not likely that investors are ready to pay good price for the securities, if managers can steal everything.
III. Legal Protection
Basically why investors are ready to invest money in the enterprise is that in theory they get control rights for that. However they are giving these rights to the managers. They are doing that because they are sure that if manager violates the rules they will have opportunity to appeal the courts to enforce their rights.
The most important right of shareholders is right to vote on important issues such as BoD election, M&A etc. However it is expensive to exercise and enforce these rights. For instance, EqHolders cannot vote via e-mail, and to vote you have to show up in another country.
One way how legal Protection protects EH: restriction of management to issue new shares to himself or his family, or demand for consulting with BoD when taking some serious actions.
However the protection of shareholders depends considerably on the legal enforcement in the country.
Like shareholders DH also have a variety of the protections, which also vary across countries. This may include right to grab the assets if debt is not repaid; convert the debt into equity etc. However authors argue that rights of DH are implemented in very inefficient way – and probably in the long run they will be implemented in more efficient way.
Conclusion: Legal protection does not provide sufficient protection for creditors to get their money back.
IV. Large Investors
If Legal Protection does not give enough control rights to the small investors, then perhaps the larger investors will be more effective control.
IV.A) Large Shareholders
If a EH has sufficient amount of shares he has incentive to monitor management. He also has some voting power to put pressure on the manager, in the extreme case if one has 51% of shares he can appoint management alone and make sure that company brings the highest profits.
Because large investors are governing by exercising their voting rights, their power depends on the legal protection of shareholders.
IV.B) Takeovers
Hostile takeover – simultaneous purchase of stocks from dispersed EH. Usually takeovers are implemented over poorly performing firms, to change management. However this is not efficient mechanism: 1) bidder has to pay quite high price to buy large amount of shares. 2) If bidding management overpay for takeover he actually pays for his Private Benefits of Control. 3) Takeovers require a liquid capital market. 4) Takeovers are politically extremely vulnerable mechanism, as since they are opposed my managers.
IV.C) Large Creditors
Significant creditors such as banks are active investors. Their power comes from numerical rights when the company defaults. Therefore Banks tend to lend short term to force firms come back periodically for additional investments.
The effectiveness of the DH as effectiveness of EH depends on the right protection. However if EH has 51% he does not need any legal protection as he may do everything he would like to do, if DH has substantial part of the company he still needs legal protection to execute his rights.
V. The Costs of Large Investors
· there is no diversification in comparison with dispersed ownership.
· if the control rights are concentrated in one hand, then most likely this large investor will care only about himself and not the minority shareholders or employees and mangers. In this case they will not pay out dividends, but rather tunnel the assets to another company which totally belongs to them.
The problem becomes even larger if there are different types of investors – if there is large EH he will try to undertake more risky projects than DH would undertake. This is called risk shifting.
VI. Specific Governance Arrangements
VI.A) Debt to Equity Choice
Benefit of debt: reducing the agency costs, because debt holder will not let manager to invest in projects with NPV, and sell assets lower than their market value.
Costs of the debt 1) there may be the case that good projects will not be undertaken as the company will not be allowed to raise additional funds for them, or 2) DH may liquidate the company when it is not efficient to do it. Also in majority of countries debt promotes concentrated ownership.
Conclusion: the DHs are tougher, because they can more easily execute their rights, and they are able to put lots of restrictions on the management. Therefore, company may prefer EH: firms doesn’t have to pay them every period, doesn’t have to repay the money which was put in the company etc. But in theory EH should not get in this type of contracts, as their rights are weakly protected. But they still get in because in short run they focus on the optimism, and in the long run on the legal protection
VI.B) LBOs
Leveraged buy outs. In these transactions shareholders of publicly owned company are bought out by the new group of investors (usually managers and banks). Authors provide evidence that these transactions are efficient as they are usually increasing firms’ value considerably.
VI.C) Cooperatives and State Ownership
Usually this structures used in health care, child care etc. Sometimes consumer run cooperatives voting on the price-quality achieve better results than profit maximizing owner. Same thing with state ownership – all monopolies should be run by the state. However as the government is too bureaucratic it causes lot of inefficiency, therefore some would argue that privatization is better; however this is not the case because lack of competition will get this inefficiency back.
VII. Which system is the best one?
A good corporate governance system should combine some type of large investors with legal protection of rights of them and small investors. Large investors force management to pay profits. Therefore American, German and Japanese Corporate Governance rules.
The CG depends heavily on the historic development of financial system. Therefore even German, Japanese and American CG are not equally good. So we cannot decide which of the systems is better.
At the same time it is not possible to determine which of the large investors’ scheme is the most convenient – each has its own costs and advantages.