CONCEPTUAL FRAMEWORK most importantly,individual investors'wealth may be small relative to the size of some investments.Second,even if a shareholder can take a large stake in a firm,he may want to diversify risk by investing less.A related third reason is investors'concern for liquidity: a large stake may be harder to sell in the secondary market.For these reasons it is not realistic or desirable to expect to resolve the collective action problem among dispersed shareholders by simply getting rid of dispersion. 4.7 Summary and Conclusion In sum,mandatory governance rules (as required by stock exchanges,legislatures,courts or supervisory authorities)are necessary for two main reasons:first,to overcome the collective action problem resulting from the dispersion among shareholders,and second, to ensure that the interests of all relevant constituencies are represented.Indeed,other constituencies besides shareholders face the same basic collective action problem. Corporate bondholders are also dispersed and their collective action problems are only imperfectly resolved through trust agreements or consortia or in bankruptcy courts.In large corporations employees and clients may face similar collective action problems, which again are imperfectly resolved by unions or consumer protection organisations. Most of the finance and corporate law literature on corporate governance focuses only on collective action problems of shareholders.Accordingly,we will emphasize those problems in this survey.As the literature on representation of other constituencies is much less developed we shall only touch on this issue in sections 5 to 7. We distinguish five main ways to mitigate shareholders'collective action problems: 28 Alternatively,limiting managerial discretion ex ante and making it harder to change the rules by introducing supermajority requirements into the corporate charter would introduce similar types of inefficiency as with debt. 21/168
CONCEPTUAL FRAMEWORK most importantly, individual investors’ wealth may be small relative to the size of some investments. Second, even if a shareholder can take a large stake in a firm, he may want to diversify risk by investing less. A related third reason is investors’ concern for liquidity: a large stake may be harder to sell in the secondary market.29 For these reasons it is not realistic or desirable to expect to resolve the collective action problem among dispersed shareholders by simply getting rid of dispersion. 4.7 Summary and Conclusion In sum, mandatory governance rules (as required by stock exchanges, legislatures, courts or supervisory authorities) are necessary for two main reasons: first, to overcome the collective action problem resulting from the dispersion among shareholders, and second, to ensure that the interests of all relevant constituencies are represented. Indeed, other constituencies besides shareholders face the same basic collective action problem. Corporate bondholders are also dispersed and their collective action problems are only imperfectly resolved through trust agreements or consortia or in bankruptcy courts. In large corporations employees and clients may face similar collective action problems, which again are imperfectly resolved by unions or consumer protection organisations. Most of the finance and corporate law literature on corporate governance focuses only on collective action problems of shareholders. Accordingly, we will emphasize those problems in this survey. As the literature on representation of other constituencies is much less developed we shall only touch on this issue in sections 5 to 7. We distinguish five main ways to mitigate shareholders’ collective action problems: 28 Alternatively, limiting managerial discretion ex ante and making it harder to change the rules by introducing supermajority requirements into the corporate charter would introduce similar types of inefficiency as with debt. 21/168
CONCEPTUAL FRAMEWORK 1)Election of a board of directors representing shareholders'interests,to which the CEO is accountable. 2)When the need arises,a takeover or proxy fight launched by a corporate raider who temporarily concentrates voting power (and/or ownership)in his hands to resolve a crisis,reach an important decision or remove an inefficient manager. 3)Active and continuous monitoring by a large blockholder,who could be a wealthy investor or a financial intermediary,such as a bank,a holding company or a pension fund. 4)Alignment of managerial interests with investors through executive compensation contracts. 5)Clearly defined fiduciary duties for CEOs and the threat of class-action suits that either block corporate decisions that go against investors'interests,or seek compensation for past actions that have harmed their interests. As we shall explain,a potential difficulty with the first three approaches is the old problem of who monitors the monitor and the risk of collusion between management (the agent)and the delegated monitor (director,raider,blockholder).If dispersed shareholders have no incentive to supervise management and take an active interest in the management of the corporation why should directors-who generally have equally small stakes-have much better incentives to oversee management?The same point applies to pension fund managers.Even if they are required to vote,why should they spend the resources to make informed decisions when the main beneficiaries of those decisions are their own principals,the dispersed investors in the pension fund?Finally,it 29 A fourth reason for the observed dispersion in shareholdings may be securities regulation designed to 22/168
CONCEPTUAL FRAMEWORK 1) Election of a board of directors representing shareholders’ interests, to which the CEO is accountable. 2) When the need arises, a takeover or proxy fight launched by a corporate raider who temporarily concentrates voting power (and/or ownership) in his hands to resolve a crisis, reach an important decision or remove an inefficient manager. 3) Active and continuous monitoring by a large blockholder, who could be a wealthy investor or a financial intermediary, such as a bank, a holding company or a pension fund. 4) Alignment of managerial interests with investors through executive compensation contracts. 5) Clearly defined fiduciary duties for CEOs and the threat of class-action suits that either block corporate decisions that go against investors’ interests, or seek compensation for past actions that have harmed their interests. As we shall explain, a potential difficulty with the first three approaches is the old problem of who monitors the monitor and the risk of collusion between management (the agent) and the delegated monitor (director, raider, blockholder). If dispersed shareholders have no incentive to supervise management and take an active interest in the management of the corporation why should directors – who generally have equally small stakes - have much better incentives to oversee management? The same point applies to pension fund managers. Even if they are required to vote, why should they spend the resources to make informed decisions when the main beneficiaries of those decisions are their own principals, the dispersed investors in the pension fund? Finally, it 29 A fourth reason for the observed dispersion in shareholdings may be securities regulation designed to 22/168
CONCEPTUAL FRAMEWORK might appear that corporate raiders,who concentrate ownership directly in their hands, are not susceptible to this delegated monitoring problem.This is only partially true since the raiders themselves have to raise funds to finance the takeover.Typically,firms that are taken over through a hostile bid end up being substantially more highly levered.They may have resolved the shareholder collective action problem,but at the cost of significantly increasing the expected cost of financial distress. Enforcement of fiduciary duties through the courts has its own shortcomings.First, management can shield itself against shareholder suits by taking out appropriate insurance contracts at the expense of shareholders.Second,the "business judgement" rule (and similar provisions in other countries)severely limits shareholders'ability to prevail in court.Finally,plaintiffs'attorneys do not always have the right incentives to monitor management.Managers and investment bankers often complain that contingency fee awards(which are typically a percentage of damages awarded in the event that the plaintiff prevails)can encourage them to engage in frivolous suits,a problem that is likely to be exacerbated by the widespread use of director and officer D&O)liability insurance.This is most likely to be the case in the US.In other countries fee awards (which mainly reflect costs incurred)tend to increase the risk of lawsuits for small shareholders and the absence of D&O insurance makes it harder to recover damages. protect minority shareholders,which raises the cost of holding large blocks.This regulatory bias in U.S. corporate law has been highlighted by Black(1990),Roe (1990,91,94)and Bhide(1993). Most large U.S.corporations have taken out director and officer liability (D&O)insurance policies(see Danielson and Karpoff 2000).See Gutierrez (2000 a,b)for an analysis of fiduciary duties,liability and D&O insurance. 31 The"director's business judgement cannot be attacked unless their judgement was arrived at in a negligent manner,or was tainted by fraud,conflict of interest,or illegality."(Clark 1986:124).The business judgement rule give little protection to directors for breaches of form (e.g.for directors who fail to attend meetings or read documents)but can extend to conflict of interest situations,provided that a self- interested decision is approved by disinterested directors(Clark 1986:123,138). 32 See Fischel and Bradley (1986),Romano(1991)and Kraakman,Park and Shavell (1994)for an analysis of distortions of litigation incentives in shareholder suits. 23/168
CONCEPTUAL FRAMEWORK might appear that corporate raiders, who concentrate ownership directly in their hands, are not susceptible to this delegated monitoring problem. This is only partially true since the raiders themselves have to raise funds to finance the takeover. Typically, firms that are taken over through a hostile bid end up being substantially more highly levered. They may have resolved the shareholder collective action problem, but at the cost of significantly increasing the expected cost of financial distress. Enforcement of fiduciary duties through the courts has its own shortcomings. First, management can shield itself against shareholder suits by taking out appropriate insurance contracts at the expense of shareholders.30 Second, the “business judgement” rule (and similar provisions in other countries) severely limits shareholders’ ability to prevail in court.31 Finally, plaintiffs’ attorneys do not always have the right incentives to monitor management. Managers and investment bankers often complain that contingency fee awards (which are typically a percentage of damages awarded in the event that the plaintiff prevails) can encourage them to engage in frivolous suits, a problem that is likely to be exacerbated by the widespread use of director and officer (D&O) liability insurance. This is most likely to be the case in the US. In other countries fee awards (which mainly reflect costs incurred) tend to increase the risk of lawsuits for small shareholders and the absence of D&O insurance makes it harder to recover damages.32 protect minority shareholders, which raises the cost of holding large blocks. This regulatory bias in U.S. corporate law has been highlighted by Black (1990), Roe (1990, 91, 94) and Bhide (1993). 30 Most large U.S.corporations have taken out director and officer liability (D&O) insurance policies (see Danielson and Karpoff 2000). See Gutierrez (2000 a,b) for an analysis of fiduciary duties, liability and D&O insurance. 31 The “director’s business judgement cannot be attacked unless their judgement was arrived at in a negligent manner, or was tainted by fraud, conflict of interest, or illegality.” (Clark 1986:124). The business judgement rule give little protection to directors for breaches of form (e.g. for directors who fail to attend meetings or read documents) but can extend to conflict of interest situations, provided that a selfinterested decision is approved by disinterested directors (Clark 1986:123,138). 32 See Fischel and Bradley (1986), Romano (1991) and Kraakman, Park and Shavell (1994) for an analysis of distortions of litigation incentives in shareholder suits. 23/168
MODELS MODELS 5.1 Takeover models One of the most radical and spectacular mechanisms for disciplining and replacing managers is a hostile takeover.This mechanism is highly disruptive and costly.Even in the U.S.and the U.K.it is relatively rarely used.In most other countries it is almost non- existent.Yet,hostile takeovers have received a great deal of attention from academic researchers.In a hostile takeover the raider makes an offer to buy all or a fraction of outstanding shares at a stated tender price.The takeover is successful if the raider gains more than 50%of the voting shares and thereby obtains effective control of the company.With more than 50%of the voting shares,in due course he will be able to gain majority representation on the board and thus be able to appoint the CEO. Much research has been devoted to the mechanics of the takeover process,the analysis of potentially complex strategies for the raider and individual shareholders,and to the question of ex-post efficiency of the outcome.Much less research has been concerned with the ex-ante efficiency of hostile takeovers:the extent to which takeovers are an effective disciplining device on managers. On this latter issue,the formal analysis by Scharfstein(1988)stands out.Building on the insights of Grossman and Hart (1980),he considers the ex-ante financial contracting problem between a financier and a manager.This contract specifies a state contingent compensation scheme for the manager to induce optimal effort provision.In addition the contract allows for ex-post takeovers,which can be efficiency enhancing if either the raider has information about the state of nature not available to the financier or if the raider is a better manager.In other words,takeovers are useful both because they reduce the informational monopoly of the incumbent manager about the state of the firm and 24/168
MODELS 5 MODELS 5.1 Takeover models One of the most radical and spectacular mechanisms for disciplining and replacing managers is a hostile takeover. This mechanism is highly disruptive and costly. Even in the U.S. and the U.K. it is relatively rarely used. In most other countries it is almost nonexistent. Yet, hostile takeovers have received a great deal of attention from academic researchers. In a hostile takeover the raider makes an offer to buy all or a fraction of outstanding shares at a stated tender price. The takeover is successful if the raider gains more than 50% of the voting shares and thereby obtains effective control of the company. With more than 50% of the voting shares, in due course he will be able to gain majority representation on the board and thus be able to appoint the CEO. Much research has been devoted to the mechanics of the takeover process, the analysis of potentially complex strategies for the raider and individual shareholders, and to the question of ex-post efficiency of the outcome. Much less research has been concerned with the ex-ante efficiency of hostile takeovers: the extent to which takeovers are an effective disciplining device on managers. On this latter issue, the formal analysis by Scharfstein (1988) stands out. Building on the insights of Grossman and Hart (1980), he considers the ex-ante financial contracting problem between a financier and a manager. This contract specifies a state contingent compensation scheme for the manager to induce optimal effort provision. In addition the contract allows for ex-post takeovers, which can be efficiency enhancing if either the raider has information about the state of nature not available to the financier or if the raider is a better manager. In other words, takeovers are useful both because they reduce the informational monopoly of the incumbent manager about the state of the firm and 24/168
MODELS because they allow for the replacement of inefficient managers.The important observation made by Scharfstein is that even if the firm can commit to an ex-ante optimal contract,this contract is generally inefficient.The reason is that the financier and manager partly design the contract to try and extract the efficiency rents of future raiders. Like a non-discriminating monopolist,they will design the contract so as to "price"the acquisition above the efficient competitive price.As a result,the contract will induce too few hostile takeovers on average. Scharfstein's observation provides an important justification for regulatory intervention limiting anti-takeover defences,such as super-majority amendments staggered boards" fair price amendments (ruling out two-tier tender offers),and poison pills(see section 7.1.4 for a more detailed discussion).These defences are seen by many to be against shareholders'interests and to be put in place by managers of companies with weak corporate governance structures (see,for example,Gilson 1981 and Easterbrook and Fischel,1981).Others,however,see them as an important weapon enabling the target firm to extract better terms from a raider (see Baron,1983,Macey and McChesney,1985, Shleifer and Vishny,1986,Hirshleifer and Titman,1990,Hirshleifer and Thakor 1994, and Hirshleifer 1995).Even if one takes the latter perspective,however,Scharfstein's argument suggests that some of these defences should be regulated or banned. 33 These amendments raise the majority rule above 50%in the event of an hostile takeover. 34 Staggered boards are a common defence designed to postpone the time at which the raider can gain full control of the board after a takeover.With only a fraction y of the board renewable every x years,the raider would have to wait up to x/2y years before gaining over 50%of the seats. 35Two-tier offers specify a higher price for the first n shares tendered than for the remaining ones.They tend to induce shareholders to tender and,hence,facilitate the takeover.Such offers are generally illegal in the U.S.,but when they are not companies can ban them by writing an amendment into the corporate charter. 3 Most poison pills give the right to management to issue more voting shares at a low price to existing shareholders in the event that one shareholder owns more than a fraction x of outstanding shares.Such clauses,when enforced,make it virtually impossible for a takeover to succeed.When such a defence is in place the raider has to oust the incumbent board in a proxy fight and remove the pill.When the pill is combined with defences that limit the raider's ability to fight a proxy fight-for example a staggered board the raider effectively has to bribe the incumbent board. 25/168
MODELS because they allow for the replacement of inefficient managers. The important observation made by Scharfstein is that even if the firm can commit to an ex-ante optimal contract, this contract is generally inefficient. The reason is that the financier and manager partly design the contract to try and extract the efficiency rents of future raiders. Like a non-discriminating monopolist, they will design the contract so as to “price” the acquisition above the efficient competitive price. As a result, the contract will induce too few hostile takeovers on average. Scharfstein’s observation provides an important justification for regulatory intervention limiting anti-takeover defences, such as super-majority amendments33, staggered boards34, fair price amendments (ruling out two-tier tender offers)35, and poison pills36 (see section 7.1.4 for a more detailed discussion). These defences are seen by many to be against shareholders’ interests and to be put in place by managers of companies with weak corporate governance structures (see, for example, Gilson 1981 and Easterbrook and Fischel, 1981). Others, however, see them as an important weapon enabling the target firm to extract better terms from a raider (see Baron, 1983, Macey and McChesney, 1985, Shleifer and Vishny, 1986, Hirshleifer and Titman, 1990, Hirshleifer and Thakor 1994, and Hirshleifer 1995). Even if one takes the latter perspective, however, Scharfstein’s argument suggests that some of these defences should be regulated or banned. 33 These amendments raise the majority rule above 50% in the event of an hostile takeover. 34 Staggered boards are a common defence designed to postpone the time at which the raider can gain full control of the board after a takeover. With only a fraction y of the board renewable every x years, the raider would have to wait up to x/2y years before gaining over 50% of the seats. 35 Two-tier offers specify a higher price for the first n shares tendered than for the remaining ones. They tend to induce shareholders to tender and, hence, facilitate the takeover. Such offers are generally illegal in the U.S., but when they are not companies can ban them by writing an amendment into the corporate charter. 36 Most poison pills give the right to management to issue more voting shares at a low price to existing shareholders in the event that one shareholder owns more than a fraction x of outstanding shares. Such clauses, when enforced, make it virtually impossible for a takeover to succeed. When such a defence is in place the raider has to oust the incumbent board in a proxy fight and remove the pill. When the pill is combined with defences that limit the raider’s ability to fight a proxy fight – for example a staggered board – the raider effectively has to bribe the incumbent board. 25/168