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Date:6thJune,2016

Reading: The Theory of Corporate Finance by Jean Tirole (Princeton University Press), Chapter 1
CorporateGovernance(excludingsection1.10)
Introduction
Aneconomicsbasetothescholar
1970sArrowDebreugeneralequilibriummodeloffrictionlessmarkets

Presumedperfectlycompetitiveandcomplete,andunhamperedbytaxes,transactioncosts,and
informationalasymmetries)
Butsaidlittleaboutfirm'sfinancialchoicesandtheirgovernance.Moralhazardruledout.
Financialmarketsassumedtobenotplaguedbyinformationasymmetry.
KeyIssueAllocationofriskamonginvestorsandpricingofredundantclaimsbyarbitrage.

1958,1963TwoMMpapers.

FirmsfinancialstructureisirrelevantinsomeconditionsorintheArrowDebreuenvironment.
Thesizeofthepieisunaffectedbythewayitiscarved.

Sincethe1980s

Principaldirectionofinquiryhasbeentointroduceagencyproblemsatvariouslevelsofthe
corporatestructure.(Managerialteam,specificclaimholders)
Attentiontoagencyconsiderationsincorporatefinancereceivedconsiderablesupportfrom
largeempiricalliteratureandfromthepracticeofinstitutionaldesign.

Ch1andCh2

Aimatprovidinganoverviewofthekeyinstitutionalfeatures,empiricalregularitiesandpolicy
issuesthatwillmotivateandguidethesubsequenttheoreticalanalysis.

Divisionoftheoreticalliteratureonmicroeconomicsofcorporatefinanceinbranches:
1. Focusesonincentivesofthefirm'sinsiders.FinancialContractingThedesignofanincentive
schemefortheinsidersthatbestalignstheinterestofthetwoparties
2. Addressesbothinsider'sandoutsider'sincentivesbytakingalesspassiveviewoftheroleof
outsiders.Subdividedinto:
a. Monitoringofmanagementbyoneorseveralsecurityholders
3. Takesintoaccounttheexistenceofinvestor'sclientelesandtherebyreturnstotheviewthat
securityholdersdifferintheirpreferencesforstatecontingentreturns.
Whiletherehavebeentremendousnumberofcontributionsonthetheoreticalfront,thereisstilllack
ofunifiedframeworkthatdisheartensstudentsofcorporatefinance.Widediscrepancyofassumptions
acrosspapersnotonlylengthensthelearningprocessbutalsomakesitdifficultforoutsiderstoidentify
thekeyeconomicelementsdrivingtheanalyses.

Chapter1:

1932,AdolfBerleandGardinerMeans:Documenttheseparationofownershipandcontrolin
theUS
Managerialdiscretioncreatedbyshareholderdispersioncanbeabused;theyareunwatched
Corporateinsidersneednotactinthebestinterestsoftheprovidersoffunds

Synopsis:
Thereadingbeingthefirstchapterhasbeenwrittenasaguidetothecompletebookwheretheauthor
brieflyintroducesvariousconceptsdealtinthebookandthegivesafairideaofthedepthofthetopicby
efficientlyinterweavingcontemporaryexampleswiththeresearchfindings.Theprimaryobjectiveof
the chapter is to explain and address the larger issue of corporate governance. The text can be aptly
labelledasasummaryoftheresearchadvancesintheareaaswellastheongoingscholarlydebates.
TheDiscussion:
Thediscussionshallbeginwiththeconceptofseparationofownershipandcontrolinacorporatebody.
The basic concern being the abuse of managerial discretion created by shareholder dispersion can be
abused.Sincemanagersareunwatched,theymaynotactinthebestinterestsoftheprovidersoffunds.
The following burning issues at hand would be the core of the discussion: Transparency, Managerial
Accountability,CorporateGovernanceFailures,WeakBoardofDirectors,HostileTakeovers,Protection
ofminorityshareholders,InvestorActivism
Theinitialsection1.11.2emphasizetheimportanceofmanagerialaccountability.Therewouldbeeffort
towards evaluating the definition of corporate governance and its scope. We shall discuss the various
forms in which dysfunctional governance can take place and the illintended efforts that toplevel
executivesputintocoverupovertheirinefficienciesorvestedinterests.Thereafter,theauthorreviews
variousinstrumentsandfactorsthathelpalignmanagerialincentiveswiththoseofthefirm:monetary
compensation,implicitincentives,monitoring,andproductmarketcompetition.
Insection1.31.6,thetextgoesintoadeepanalysisoftheconceptofmonitoring.Weshalldelveintothe
variousformsofmonitoringandtheirintricacies.Thediscussionshallmajorlyinvolvethevariousbodies,
bothinsideandoutsidethefirm,andmechanismswhichhelpinkeepinganeyeontheinsiders.Fromthe
boardsofdirectors,largeshareholders,raiders,andbankstodebtasamechanismwillbediscussedto
understandtheroles,responsibilitiesandrelatedregulations.Also,amajorpartofthediscussionwould
involvethelimitationsfacedbyeachofthebodies.
Section1.7discussesthedifferencesincorporategovernancesystems.Thediscussionwouldinvolvethe
followingbasisfordrawingoutrelevantdifferences:Commonlaw,Civillaw,shareholderprotectionand
creditorprotection.
Intheend,discussionwouldbeconcludedovertheobjectiveofthefirm,namely,whommanagers
shouldbeaccountableto,andthelongstandingdebatebetweentheproponentsofthestakeholder
societyandthoseofshareholdervaluemaximization.

1.1

TheAgencyproblem:StrongManagersandDispersedShareholders
1990s:CommitteesandcodesforbestpracticeforBoardsstartedcomingin
CorporateGovernancedefinition:
o Waysinwhichthesuppliersoffinancetocorporationsassurethemselvesofgettinga
returnontheirinvestment[ShleiferandVishnys(1997)andBechtetal.(2002)]
o toonarrowasadefinitionwithonlyfocusoninvestor'sreturns;stakeholdersignored
o Booksubscribestothenarrowview

1.1.1
Fourcategoriesofmoralhazard:
A. InsufficientEffort
Theissueisnotthenumberofhoursspentintheofficebuttheallocationofworktime
tovarioustasks
InconvenienceandUnpleasantnessin:
i. Switchingtoalesscostlysupplier
ii. Reallocatingtheworkforce
iii. Takingatougherstanceinwagenegotiations
Insufficientefforttotheoversightofsubordinates(Internalcontrol)
Overcommitmenttocompetitiveactions:politicalinvolvement,investmentsinother
ventures,andmoregenerallyactivitiesnotorlittlerelatedtomanagingthefirm

B. ExtravagantInvestments
Engagementinpetprojectsandempirebuildingtothedetrimentofshareholders
Firmsearningwindfallcashawardsincourtdonotreturnthecashtoinvestorsand
spenditinefficiently

C. EntrenchmentStrategies
Oftenexecutivestakeactionsthathurtshareholderstokeeptheirpositionsecure
Investinactivitiesthatmakethemindispensable(ShleiferandVishny,1989)
Manipulateperformancemeasuressoastolookgoodwhentheirpositionmightbe
threatened.E.g.creativeaccountingtechniques,excessiveorinsufficient
Actingexcessivelyconservativewhentheirperformanceissatisfactory,takingexcessive
riskandthusgambleforresurrection
Managersroutinelyresisthostiletakeovers,asthesethreatentheirlongtermpositions.
E.g.defeatingattractivetenderofferstoshareholders,findinga"whiteknight",
concludinganonaggressionpactwiththeraider,limitingshareholderactivism

D. SelfDealing
Managersmayconsumeperks;Pickingtheirsuccessor,whowouldn'tcriticizeorcast
shadowontheirpastmanagement;Contractingonfriendshipandkinshipgrounds;
Financingpoliticalparties

Engaginginillegalactivitiesandinsidertrading

Moralhazardalleviationscantaketworoutes:

Insider'sincentivesmaybepartlyalignedwithinvestor'sinterests:Performancebased
incentives
InsidersaremonitoredviaBoard,potentialshareholders,debtholders

1.1.2
"Tipoftheiceberg"Managerialmisbehavior,submergedpartinstitutionalresponseandmanagerial
incentivecontracts

FormsofDysfunctionalGovernance:
A. LackofTransparency
Imperfectlyinformedoutsidepartiesabouttopmanagementcompensations;limited
transparencyofmanagerialstock;perksareunknowntoinvestors;recruitingfamilyand
friendsforimportantpositions
B. Level
Substantialincreaseintotalcompensationpackages;
Proponentsofhighlevelcompensationpointtowardsperformancebasedpay

C. Thinlinkbetweenperformanceandcompensation.Reasons:
Poorlystructuredpackages
Managersseentomanagetomaintaintheircompensationstableorevenhaveit
increaseddespitepoorperformance
Gettingoutontime
Largegoldenparachutes

D. AccountingManipulations
Legalandillegalmanipulationstoinflatecompanyperformance.Purposesserved:
i. Increasetheapparentearningsand/orstockprice
ii. Protectmanagersagainstdismissalsortakeoversorreduceinvestor
interference
iii. Nottoviolatebankcovenantsandenablecontinuedfinancing
1.2.1
Bonusesandstockoptionsmakemanagerssensitivetolossesinprofitandinshareholdervalue.Implicit
incentives,fearofbeingfiredandfutureprospectskeepmanagersontheirtoes.
1.2.2

Thecompensationpackage:Salary+Bonus+Stockbasedincentives.Dramaticincreaseinstock
options.

"someloopholesthatallowmanagerstoundosomeoftheirexposuretothefirmsprofitability
throughlessstrictlyregulatedfinancialinstruments,suchasequityswapsandcollars"
Bonusesandshareholdings:substitutesorcomplements?
bonusesandstockoptionsservetwodifferentandcomplementarypurposes;bonuses
createsshorttermincentivewhilestockbasedincentivesencouragemanagementto
takealongtermperspective
Thecompensationbase
compensationshouldbebasedonfactorsthatarenotoutsidethecontrolofthe
manager;indexingcompensationtotherelevantvariables;itmustalsobeunaffectedby
therealizationofexogenousshocks
Relativeperformanceevaluation
CEOsareconsequentlyrewardedforluck
Shouldmanagersberewardedthroughstraightsharesorthroughstockoptions?

Executivecompensationcontroversy
Upwardtrendandemphasisonperformancelinkedpackages
JensenandMurphyarguethatCEOincentivesnottowasteshareholdervaluearetoo
small.

1.2.3
ImplicitIncentives

Riskoflosingpositiononpoorperformance
Increasedmonitoring
ThereisafairamountofevidencethatexecutiveturnoverintheUnitedStatesiscorrelatedwith
poorperformance,usingeitherstockoraccountingdata
Areexplicitandimplicitincentivescomplementsorsubstitutes?

1.2.4
Monitoring

Activemonitoring:forwardlooking,exerciseofcontrolrights
largeshareholder,institutionalinvestor,raider,creditors
Speculativemonitoring:backwardlooking,
toadjusthispositioninthefirm,legalsuitsbyshareholders
Largenumberofothereyeballs:besidesstockanalysts,ratingagencies,auditors

Conflictofinterest

1.2.5

ProductMarketCompetition

firmscompetitiveenvironment
closecompetitorsofferayardstick
tendstofilteroutorattenuatetheexogenousshocksfacedbythefirm
alsocreatesperverseeffects
competitioncanneversubstituteforgovernance

1.3
TheBoardofDirectorsmonitorsmanagementonbehalfofshareholders

1.3.1
BoardsofDirectors:WatchdogsorLapdogs?

Lackofindependence
Aboutexecutivechairmanship
Insufficientincentives
Shareholderlawsuits
Avoidanceofconflict

1.3.2
ReformingtheBoard

Teammatesorreferees?
Knowledgeversusindependence?
Whatcanlinkfromperformancetoboardcompensation?
CalPERSList

1.4
InvestorActivism
1.4.1
InvestorActivismComesinManyGuises

Activemonitoringrequirescontrol:MajorityandMinority
Proxyfights.

Astockholderoragroupofstockholdersunhappywithmanagerialpoliciesseekseitherelectiontothe
boardofdirectorswiththeultimategoalofremovingmanagement,orsupportbyamajorityof
shareholdersforaresolutiononaspecificcorporatepolicy.

1.4.2
PatternofOwnership

Ownershipconcentration
Crossshareholdings
Stableholdingsversusactiveportfoliomanagement

1.4.3
TheLimitsofActiveMonitoring

Whomonitorsthemonitor?
Institutionalmoneymanagers
Congruencewithotherinvestors
Undermonitoring
Collusionwithmanagement
Selfdealing
Costofprovidingproperincentivestothemonitor
Perverseeffectsonthemonitorees
Legal,fiscal,andregulatoryobstacles

1.5
TakeoversandLeveragedBuyouts

perceivedwithawe,horror,andadmiration
representtheworstofanAmericancapitalismbasedongreedandmyopia
originalmodeofcorporategovernancethatsubstitutesefficientteamsforentrenched,money
wastingmanagers

1.5.1
TakeoverBidsandDefenses
Theideabeingthatthebidderisofteninterestedinthesharesonlyifheobtainsacontrollingstake
Defenses

Corporatecharterdefenses
Supermajorityrule

Fairpriceclauses
Differentialvotingrights
Movetoastatewithtougherantitakeoverstatutes
Scorchedearthpolicies
Enteringlitigation
Poisonpills
Whiteknight
Greenmail

1.5.2
LeveragedBuyouts
Takingafirmprivatebypurchasingitssharesandallocatingthemtoaconcentratedownership
composedofmanagement,ageneralpartner,andotherinvestors
Concerningleverage,LBOtargetshavetogeneratelargeandsteadycashflowsinordertoservicethe
highdebtpayments
1.5.3
TheRiseofTakeoversandtheBacklash:WhatHappened?

Hypothesis1:Declineofcorporategovernance
Hypothesis2:Financialinnovation
Hypothesis3:Breakupofconglomerates

1.6
DebtasaGovernanceMechanism
1.6.1
DebtasanIncentiveMechanism

preventsmanagersfromconsumingcash
incentivizesthecompanysexecutivesforservicingdebt
threatofilliquidityhasapositivediscipliningeffect
intheabsenceofliquidation,thenonrepaymentofdebtputsthecreditorsinthedriversseat
managersholdasubstantialamountofclaimsoverthefirmscashflow,debtholdingby
investorshasbenefits

1.6.2
LimitstoDebtasaGovernanceMechanism

Costofilliquidity
Bankruptcycosts
Transactioncosts
Bargaininginefficiencies

1.7
InternationalComparisonsofthePolicyEnvironment

Commonlaw:Englishspeakingcountries,emphasizesjudiciaryindependence,reactivityto
precedents,andlimitedcodification
Civillaw,incontrast,stressescodification
Protectionofshareholdersisstrongestincommonlawcountries,weakestinFrenchstylecivil
lawcountries
LaPortaetal.(1997)Apositivecovariationbetweenshareholderprotectionandthebreadthof
theequitymarket

1.8
ShareholderValueorStakeholderSociety?
Awidespreadviewinpoliticsandpublicopinionisthatcorporationsshouldservealargersocialpurpose
andberesponsible,thatis,theyshouldreachouttootherstakeholdersandnotonlytoshareholders.
1.8.1
TheCorporateSocialResponsibilityView

Dutiestowardemployees
Dutiestowardcommunities
Dutiestowardcreditors
Ethicalconsiderations

Thepopularityofthestakeholdersocietyviewinthepublicistobecontrastedwiththestrong
consensusamongfinancialeconomiststhatmaximizingshareholdervaluehasmajoradvantagesover
thepursuitofalternativegoals.

1.8.2
WhattheStakeholderSocietyIsandWhatItIsNot
recommendationistotreatemployeesfairlythroughjobsecurity,trainingfacilities,etc.Thereasoningis
that,bybuildingareputationforfairness,thefirmwillbeabletoattractthemosttalentedemployees
andtoinducethemtoinvestinthefirm,astheemployeeswillknowthattheyareengagedinalong
termrelationshipwiththefirmandthattheirfirmspecificinvestmentswillberewarded.

whydoesoneneedalawinthefirstplace?

1.8.3
ObjectionstotheStakeholderSociety

givingcontrolrightstononinvestorsmaydiscouragefinancinginthefirstplace
Theissuewiththesharingofcontrolbetweeninvestorsandnaturalstakeholdersisnotonlythat
itgenerateslesspledgeableincomeandthereforelessfinancingthaninvestorcontrol,butalso
thatitmaycreateinefficienciesindecisionmaking.
theconceptofstakeholdersocietyismanagerialaccountability