Chapter 10 Corporate Governance 10.1 The market for corporate control The agency problem that arises from the separation of ownership and control (Berle and Means, 1932)has been a major focus of the literature on corporate finance and the theory of the firm over the last twenty years. Various insti- tutional arrangements exist to deal with this agency problem and one that has attracted a lot of attention is the market for corporate control. Manne (1965) suggested that, if a publicly traded company is badly managed and the usual methods of corporate governance(board of directors, proxy bat tles, etc )are not effective in disciplining the management, a hostile takeover llows an outsider to acquire a controlling interest in the firm, change the management, and realize an increase in shareholder value Grossman and Hart(1980) provided a formal analysis of how the mar- ket for corporate control functions and pointed out the existence of a free- rider problem that may prevent takeovers from maximizing shareholder value Here is a brief sketch of the model. The manager of a firm chooses an action a E A and the resulting value of the firm is denoted by V(a). Suppose the firm is under the control of an incumbent manager who for some reason(e.g incompetence or private benefits) is not maximizing shareholder value. The optimal action is a* but the manager chooses a. If a raider acquires control of the firm and changes the action from a to a*, social surplus increases V(a-V(a)and this gain in surplus can be shared between the raider the shareholders A hold-out' problem arises because the existing shareholders anticipate
Chapter 10 Corporate Governance 10.1 The market for corporate control The agency problem that arises from the separation of ownership and control (Berle and Means, 1932) has been a major focus of the literature on corporate finance and the theory of the firm over the last twenty years. Various institutional arrangements exist to deal with this agency problem and one that has attracted a lot of attention is the market for corporate control. Manne (1965) suggested that, if a publicly traded company is badly managed and the usual methods of corporate governance (board of directors, proxy battles, etc.) are not effective in disciplining the management, a hostile takeover allows an outsider to acquire a controlling interest in the firm, change the management, and realize an increase in shareholder value. Grossman and Hart (1980) provided a formal analysis of how the market for corporate control functions and pointed out the existence of a freerider problem that may prevent takeovers from maximizing shareholder value. Here is a brief sketch of the model. The manager of a firm chooses an action a ∈ A and the resulting value of the firm is denoted by V (a). Suppose the firm is under the control of an incumbent manager who for some reason (e.g., incompetence or private benefits) is not maximizing shareholder value. The optimal action is a∗ but the manager chooses a¯. If a raider acquires control of the firm and changes the action from a¯ to a∗, social surplus increases by V (a∗) − V (¯a) and this gain in surplus can be shared between the raider and the shareholders. A ‘hold-out’ problem arises because the existing shareholders anticipate 1
CHAPTER 10. CORPORATE GOVERNANCE an increase in value if the raider successfully takes control of the firm. The shareholders will be unwilling to tender their shares unless they are paid the full anticipated value. If takeovers are costly, the raider will undertake a takeover only if he anticipates a positive profit. But if the raider has to pay the full price he gets no profit from the takeover To make this argument precise, consider the following game form The raider offers a price p for the shares of the firm and pays a fixed cost C>0(the cost of organizing the tender offer) . Each shareholder has a single share. which he can tender or retain If the raider acquires a fraction 0< l of the shares, he acquires control and can choose the action that maximizes the value of the firm If the fraction of shares tendered is less than y, the offer fails and the ncumbent management is left in control The equilibria of this game can be characterized by looking at these stages At the last stage, if the raider has acquired a fraction g> y of the shares, he gets control, chooses the optimal action a, and the value of the firm is V(). If he acquires a fraction g y, the incumbent manager remains in control, the firms policy is unchanged, and the value of the firm is v(a) At the second stage, the shareholder receives the price p if he tenders his share. if he holds onto his share and the offer fails. his share is worth V(a). If he holds onto his share and the offer succeeds, his share is worth V(a). Thus, he will tender his share if p>v(a)(resp p>V(a*) and hold onto it if p< v(a)(resp. p< V(a)) At the first stage, the raider must offer a price that equals the share- holders'reservation price to succeed. Thus, the offer can succeed only If the raider acquires a fraction g> y of the shares, his profit is (p-V(a))9-C<0
2 CHAPTER 10. CORPORATE GOVERNANCE an increase in value if the raider successfully takes control of the firm. The shareholders will be unwilling to tender their shares unless they are paid the full anticipated value. If takeovers are costly, the raider will undertake a takeover only if he anticipates a positive profit. But if the raider has to pay the full price he gets no profit from the takeover. To make this argument precise, consider the following game form: • The raider offers a price p for the shares of the firm and pays a fixed cost C > 0 (the cost of organizing the tender offer). • Each shareholder has a single share, which he can tender or retain. • If the raider acquires a fraction 0 <γ< 1 of the shares, he acquires control and can choose the action that maximizes the value of the firm. If the fraction of shares tendered is less than γ, the offer fails and the incumbent management is left in control. The equilibria of this game can be characterized by looking at these stages in reverse order. • At the last stage, if the raider has acquired a fraction g ≥ γ of the shares, he gets control, chooses the optimal action a∗, and the value of the firm is V (a∗). If he acquires a fraction g<γ, the incumbent manager remains in control, the firm’s policy is unchanged, and the value of the firm is V (¯a). • At the second stage, the shareholder receives the price p if he tenders his share. If he holds onto his share and the offer fails, his share is worth V (¯a). If he holds onto his share and the offer succeeds, his share is worth V (a∗). Thus, he will tender his share if p>V (¯a) (resp. p>V (a∗)) and hold onto it if p<V (¯a) (resp. p<V (a∗)). • At the first stage, the raider must offer a price that equals the shareholders’ reservation price to succeed. Thus, the offer can succeed only if p ≥ V (a∗). If the raider acquires a fraction g ≥ γ of the shares, his profit is (p − V (a∗ ))g − C < 0
10.1. THE MARKET FOR CORPORATE CONTROL So it appears that a takeover cannot succeed grossman and hart suggest that dilution of the existing shareholders property rights may provide the raider with sufficient profit to undertake the raid. Suppose that the dilution ratio is o, that is, the raider can capture a fraction of the minority shareholders' property rights by self-dealing, etc Then the price offered must satisfy p2(1-oV(a*) and a successful tender offer is possible if oV(a)≥C. Bagnoli and Lipman(1987) point out that the Grossman Hart model with a continuum of shareholders is special Abstract: We noted at the outset that most of the literature on takeovers assumes atomistic stockholders. As we pointed out however, there are many large firms for which this assumption is obviously inappropriate. This led us to consider the finite stock- holder game. We showed that there are substantial differences between the finite game and the atomistic stockholder models In particular, because some stockholders must be pivotal and hence cannot free ride, successful takeovers are possible without exclusion. Since the equilibrium outcome in the finite stockholder game is quite different from the atomistic stockholder outcome the natural question to ask is under what conditions the atom- istic stockholder outcome obtains for firms which are sufficiently widely held. We showed that the atomistic stockholder outcome does not obtain in the infinite stockholder game. We also showed that the difference between the finite and atomistic stockholder outcomes may not vanish in the limit. We argued that atom- istic stockholder models may provide a reasonable appl to the outcome for takeovers with any-and-all bids if the firm is not sufficiently valuable relative to the dispersion of stock owner ship. Otherwise, the finite stockholder model is likely to provide a more accurate prediction, so that exclusion is not necessary for successful takeovers. Since, all else equal, stockholders generally benefit more from takeovers without exclusion, our analysis sug gests that stockholders would prefer to invest in firms which are valuable relative to the dispersion of stock ownership. This, in turn, suggests that a given firms stock will not be"too"widely
10.1. THE MARKET FOR CORPORATE CONTROL 3 So it appears that a takeover cannot succeed. Grossman and Hart suggest that dilution of the existing shareholders’ property rights may provide the raider with sufficient profit to undertake the raid. Suppose that the dilution ratio is φ, that is, the raider can capture a fraction φ of the minority shareholders’ property rights by self-dealing, etc. Then the price offered must satisfy p ≥ (1 − φ)V (a∗) and a successful tender offer is possible if φV (a∗ ) ≥ C. Bagnoli and Lipman (1987) point out that the Grossman Hart model with a continuum of shareholders is special. Abstract: We noted at the outset that most of the literature on takeovers assumes atomistic stockholders. As we pointed out, however, there are many large firms for which this assumption is obviously inappropriate. This led us to consider the finite stockholder game. We showed that there are substantial differences between the finite game and the atomistic stockholder models. In particular, because some stockholders must be pivotal and hence cannot free ride, successful takeovers are possible without exclusion. Since the equilibrium outcome in the finite stockholder game is quite different from the atomistic stockholder outcome, the natural question to ask is under what conditions the atomistic stockholder outcome obtains for firms which are sufficiently widely held. We showed that the atomistic stockholder outcome does not obtain in the infinite stockholder game. We also showed that the difference between the finite and atomistic stockholder outcomes may not vanish in the limit. We argued that atomistic stockholder models may provide a reasonable approximation to the outcome for takeovers with any-and-all bids if the firm is not sufficiently valuable relative to the dispersion of stock ownership. Otherwise, the finite stockholder model is likely to provide a more accurate prediction, so that exclusion is not necessary for successful takeovers. Since, all else equal, stockholders generally benefit more from takeovers without exclusion, our analysis suggests that stockholders would prefer to invest in firms which are valuable relative to the dispersion of stock ownership. This, in turn, suggests that a given firm’s stock will not be “too” widely
CHAPTER 10. CORPORATE GOVERNANCE held relative to its value. This seems like an interesting topic for future research The essential idea is captured by the following game. Suppose there is a finite number of shareholders i= 1.n and shareholder i holds a fraction Bi of the firm's shares. The game is the same as above except that each shareholder i can tender a fraction t i 0i of his shares and the raid succeeds if and only if t;≥ If the tender price is p the payoff to shareholder i is ui(p, t) (62-t)V(a)+tpif∑:t≥ (02-tV(a)+tpif∑;t<y Suppose that v(a)<p<v(a). Since we assume the offer succeeds if only if > y, each shareholder will minimize his offer subject to constraint. Any further reduction would cause the offer to fail and his payoff would fall. For any p>v(a) it is optimal for agents to submit the maximum t i if the tender offer is expected to fail and the minimum consistent with ∑:t1≥ if it is expected to succeed. In a spe the raider will offer p≤V(a) and the shareholders will choose to offer amounts t: such that >iti2y If p< v(a)there exists a trivial continuation equilibrium in which ti=0 for all i if 0i y for each i The equilibrium constructed here depends crucially on the assumption that the fraction of the shares needed for control is known with certainty so that every shareholder is pivotal. Introducing a small amount of uncertainty could upset this equilibrium Holmstrom and Nalebuff(1992) study mixed strategy equilibria of the finite game Abstract: This paper reexamines Grossman and Hart's(1980)in- sight into how the free-rider problem excludes an external raider from capturing the increase in value it brings to a firm. The inability of the raider to capture any of the surplus depends criti- cally on the assumption of equal and indivisible shareholdings-the one-share-per-shareholder model. In contrast, we show that once shareholdings are large and potentially unequal, a raider may cap- ture a significant part of the increase in value. Specifically, the
4 CHAPTER 10. CORPORATE GOVERNANCE held relative to its value. This seems like an interesting topic for future research. The essential idea is captured by the following game. Suppose there is a finite number of shareholders i = 1, ..., n and shareholder i holds a fraction θi of the firm’s shares. The game is the same as above except that each shareholder i can tender a fraction ti ≤ θi of his shares and the raid succeeds if and only if X i ti ≥ γ. If the tender price is p the payoff to shareholder i is ui(p, t) = ½ (θi − ti)V (a∗) + tip if P i ti ≥ γ (θi − ti)V (¯a) + tip if P i ti < γ. Suppose that V (¯a) <p<V (a∗). Since we assume the offer succeeds if and only if P i ti ≥ γ, each shareholder will minimize his offer subject to this constraint. Any further reduction would cause the offer to fail and his payoff would fall. For any p>V (¯a) it is optimal for agents to submit the maximum ti P if the tender offer is expected to fail and the minimum consistent with i ti ≥ γ if it is expected to succeed. In a SPE the raider will offer p ≤ V (¯a) and the shareholders will choose to offer amounts ti such that P i ti ≥ γ. If p<V (¯a) there exists a trivial continuation equilibrium in which ti = 0 for all i if θi < γ for each i. The equilibrium constructed here depends crucially on the assumption that the fraction of the shares needed for control is known with certainty so that every shareholder is pivotal. Introducing a small amount of uncertainty could upset this equilibrium. Holmstrom and Nalebuff (1992) study mixed strategy equilibria of the finite game. Abstract: This paper reexamines Grossman and Hart’s (1980) insight into how the free-rider problem excludes an external raider from capturing the increase in value it brings to a firm. The inability of the raider to capture any of the surplus depends critically on the assumption of equal and indivisible shareholdings—the one-share-per-shareholder model. In contrast, we show that once shareholdings are large and potentially unequal, a raider may capture a significant part of the increase in value. Specifically, the
10. 2. BENEFITS OF MANAGERIAL INDEPENDENCE free-rider problem does not prevent the takeover process when shareholdings are divisible Grossman and Hart(1988 )study the design of the firms corporate charter to optimize the role of takeovers in maximizing the value of the firm. There is a tradeoff between making the firm too difficult to take over and thus protecting incumbent management and making it too easy and allowing the existing shareholders to be exploited in a corporate control contest Abstract: This paper analyzes the optimality of the one share-one vote rule. The authors focus on takeover bids as a mechanism for locating control. They assume two types of control benefits- benefits to security holders and private benefits to the controlling party. One share-one vote maximizes the importance of benefits to security holders, relative to benefits to the controlling party, and. hence encourages the selection of an efficient management team. However, one share-one vote does not always maximize the reward to security holders in a corporate control contest. Suffi cient conditions are given for one share-one vote to be optimal overall. The paper also includes a discussion of the empirical evidence 10.2 Benefits of managerial independence The agency approach assumes that the manager is in control of the firm that his interests are opposed to the interests of the shareholders, and that the shareholders maximize their interess by exerting control over his actions This is a useful complement to the traditional idea that managers maximize shareholders' preferences. How realistic is this view of the modern publicly traded company? In this section, we present a model of managerial indepen- dence and show that maximum control may not be optimal We assume that the interests of managers and shareholders are imper fectly aligned. Specifically, the manager has an incentive to overinvest. How- ever, the manager also has superior information about the efficient level of investment. The essential idea is that the shareholders may want to give the manager discretion in order to take advantage of his superior information even if discretion is costly because it allows overinvestment
10.2. BENEFITS OF MANAGERIAL INDEPENDENCE 5 free-rider problem does not prevent the takeover process when shareholdings are divisible. Grossman and Hart (1988) study the design of the firm’s corporate charter to optimize the role of takeovers in maximizing the value of the firm. There is a tradeoff between making the firm too difficult to take over and thus protecting incumbent management and making it too easy and allowing the existing shareholders to be exploited in a corporate control contest. Abstract: This paper analyzes the optimality of the one share-one vote rule. The authors focus on takeover bids as a mechanism for allocating control. They assume two types of control benefits– benefits to security holders and private benefits to the controlling party. One share-one vote maximizes the importance of benefits to security holders, relative to benefits to the controlling party, and, hence, encourages the selection of an efficient management team. However, one share-one vote does not always maximize the reward to security holders in a corporate control contest. Suffi- cient conditions are given for one share-one vote to be optimal overall. The paper also includes a discussion of the empirical evidence. 10.2 Benefits of managerial independence The agency approach assumes that the manager is in control of the firm, that his interests are opposed to the interests of the shareholders, and that the shareholders maximize their interess by exerting control over his actions. This is a useful complement to the traditional idea that managers maximize shareholders’ preferences. How realistic is this view of the modern publicly traded company? In this section, we present a model of managerial independence and show that maximum control may not be optimal. We assume that the interests of managers and shareholders are imperfectly aligned. Specifically, the manager has an incentive to overinvest. However, the manager also has superior information about the efficient level of investment. The essential idea is that the shareholders may want to give the manager discretion in order to take advantage of his superior information, even if discretion is costly because it allows overinvestment