Archive for November, 2012

The case for Corporate Governance

November 18, 2012 Leave a comment

Mr. Lipton, the poisson pill inventor back in 1982, recently wrote “The shareholder as owner, principal-agent model is a flawed model as applied to the modem public company. It does not provide an affirmative basis for the adoption of shareholder access proposals”, (“Twenty-Five Years After Takeover Bids in the Target’s Boardroom: Old Battles, New Attacks and the Continuing War”.This led me to revisit the theories that back some usual Corporate Governance principles of our days.

Corporate Governance is supported by several theories, basically the Principal-Agent one, based on information asymmetries, but it is not the only one. Let`s review the different foundations, not always disconnected among themselves.

  1. The Agency Theory.

Adam Smith, (1776), Bearle and Means, (1932), first explain their concern about separation of management and ownership. But the seminar contribution arrives in 1976 with Jensen&Meckling`s “Theory of the firm; management behavior, agency costs and ownership structure”.

Managers, (agents), are hired to maximize shareholders`s returns, (they are principals). As they do not own the corporations`s resources, they may act in their own interest, at the cost of principals. What follows is, first, an efficient split of risk bearing among agents and principals, and second, a correct monitoring through contractual monitoring and bonding. The aim is minimizing the efficiency losses, or “agency costs”.These costs are (i) monitoring costs, (incentive systems, incomplete contracting, and monitoring), (ii) bonding costs, (resources spent in assuring principals that no action against their interests will be done), and (iii) residual losses, (those not prevented from occurring in any case).

Jensen and Meckling do not advance in their view on how corporations establish monitoring systems. Fama, (Agency Problems and the Theory of the Firm, 1980), develops the idea in that sense. Internal and external managerial labor markets are the discipline enhancers in the firm. Risk bearers, (security owners and residual claimants), can sell their stakes with no relevant transaction costs in the capital markets, but rely on an efficient market that correctly values securities. Managers can expect the human capital market to correctly value their services, according to their previous experiences related to firm failure or success, so that they have correct incentives to behave to maximize firm`s performance. On the other hand, internal managers` pressures also force managers at the top to pursue the firm`s best performance, (all managers putting pressure for their future wage maximization). This would work jointly with certain monitoring systems.  The board is the system through which top managers are monitored: it should not be controlled by security owners, (given their diversified portfolios), nor managers, (if they supervise themselves, they would tend to extract wealth from security owners), but include also outsiders, (they would be controlled by their services` markets); for other resources, there may be other more efficient features so that they defend their interests, (unions and so on would control managers on their behalf), rather than participating in the Board. The capital market takeover threat represents for Fama only a last resort mechanism, given the obstacles it confronts in the case of big corporations.

Fama and Jensen, (“Separation of ownership and control”, 1983), argue that firms efficiently separate decision management and decision control rights, both at the top, (managers and board) and lower levels, (managers and workers). Managers keep for themselves Initiation and Implementation, with the specific knowledge required. The risk bearers keep decision control rights, (ratification and monitoring). Whenever risk bearing is diffused, residual claimants are also separated from decision control, thus agency costs appearing. Separating decision management and control helps avoiding those costs, allowing valuable knowledge being hired at every corner of the organization. And the Board, as a body that holds ratification and monitoring powers, is helpful in that process.

  1. The Transaction Costs economic foundation for Corporate Governance.

Following Hart, (“Corporate Governance: Some theory and implications”, 1995), agency costs are not enough to justify governance principles, as contracts could be drafted to reward agents in a performance based system, (that would avoid agency costs). Nevertheless, contracts are incomplete, and cannot include all future events with the corresponding rewards, (because of the cost of thinking all possible events, the cost of negotiating them all, and the cost of writing an enforceable contract).Corporate governance establishes a mechanism to allocate residual rights of control over the firm`s non human assets, when their usage has not been settled previously.

Following Williamson, (Corporate finance and Corporate Governance, 1988), the transaction costs theory introduces the agent`s bounded rationality and opportunism. So, governance is about crafting governance structures that save on bounded rationality, while avoiding opportunism. “Incomplete contracting in its entirity”, introduces the need to be aware of prospective misinformation, and the need to (i) realign incentives and (ii) draft governance structures that fill the gaps. The Board is an endogenous development to safeguard equity financing. Transaction costs are considered ex post: (i) maladaptation costs when misalignment appears in relation to the “shifting contract curve”, (ii) bilateral costs incurred to obtain alignment, (iii) cost of governance structures, and (iv) bonding costs, the first being the key feature. Williamson introduces the idea that the debt equity choice is not only a corporate finance concern, but also a governance one, related to asset specificity, (that favours equity, with a more intrusive oversight and involvement through the Board of Directors). The boards reduce cost of capital when assets are specific and not redeployable, (a case in which debt imposes too high a burden).

  1. The Resource Dependence Theory.

Udayasankar, (The foundations of Governance Theory: a case for the Resource-Dependence Perspective, 2005), refers to a resource based view of firm performance, where the focus is on how the firm generates unique and valuable resources, and to the fact that Corporate Governance may help in that process, instead of being just a tool for the preservation of existing assets and profits in the firm, and their correct distribution. Following Pfeffer and Salanchik, (1978), directors, through their linkages can procure expertise, reputation and a positive valuation of the firm, legitimacy, and so on; they can also provide tools to afford uncertainty, and help for the firm to generate, maintain and develop specific assets and knowledge, which result in the competitive advantage of the firm. The model is compatible with shareholder maximization, as governance would help bring capital in a differential manner, (helping to deal with agency costs, thus this theory remaining embedded in Resource-dependence theory).

  1. The Stakeholder Theory.

Donaldson and Preston, (The stakeholder theory of the corporation: concepts, evidence and implications, 1995), argue with many that corporations have stakeholders, (owners of a constellation of cooperative and competitive interests with intrinsic value, all of them embedded in the firm). And their support relies on the Property Rights theory, (which is slightly ironic, if the theory is to be opposed to the maximization for shareholders theories). Property is a bundle of many rights, (Coase, and others), some of them restricted. If rights are relations among humans, property rights cannot be separated from human rights, and consequently that introduces restriction on the use of rights because of others`interests. So, managers do not act solely on behalf of owners. The managerial implications are: a) Who is a legitimate stakeholder, (one having a contract with the firm, belonging to its broad community, receivers of either benefits or costs, etc), and b) How do managers need tobehave? They need to be aware of those interests, but the danger of opportunism still remains, so the theory needs to be developed in rules and sanctions. Mahoney, Asher, and Mahoney argue that all the economic value generated for all stakeholders needs to be considered, and all relationships also, so as to understand how the value is distributed, (instead of only considering distribution of profits to shareholders).

Although it is difficult to disagree with Mr Lipton that all those theories may lack a sound empirical and thus normative foundation, there is just enough evidence that when corporations are controlled by managers, without an appropriate corporate governance framework, it is not guaranteed that all interests affected by the firm performance are well and fairly treated, that the distribution of economic value is fair, and survival assured.


The case for and against Poison Pills

November 11, 2012 Leave a comment

A poison pill can be defined as a security issued by a target company and granted to current shareholders, convertible into ordinary shares in case that a not friendly investor surpasses a certain ownership threshold, and was a 1982 invention by Mr. Lipton, (ML) a partner in Watchell, Lipton, Rosen and Katz. The security can be issued when the investor reaches 10% and may be converted in case he hits 40%, for instance.

In June 2002, Professor Bebchuk (PB) published an article against that practice, that we will follow in its main aspects, as we will follow (ML) Mr. Lipton`s answer, published only a short time after.

The question is whether boards should have the power to block unsolicited takeover bids. PB first argues the existence of mechanisms assuring undistorted choice by shareholders, is a valid argument against that board veto. A poison pill implies a hostile bidder would only succeed if he won a ballot to replace incumbent directors for others that would redeem the pill. The board should only have time to prepare alternatives for shareholders`consideration. Other veto tools often used are staggered boards, dead hand pills, deferred redemption pills, etc.

In 1985, the Delaware Court, in four cases stated the following, in favour of the poison pill, supporting ML`s proposal:

–         Directors would be forced to use a judgement on the value of the corporation, not the market value when deciding on takeover issues,

–         Directors should use an objective business judgement, being responsible for their good faith, when deciding on takeover issues,

–         Directors duty entails maximizing short-term value after deciding for a takeover, not before,

–         A poison pill is said to be acceptable until shareholders decide to replace directors,

Ensuring an undistorted shareholder choice.

PB proposes a “Voting and no Board veto system”:

  1. In a takeover bid, the pressure to tender is huge, as a lonely shareholder can expect the value of his illiquid stock after a bid has succeeded, would be minor than the bid price. Enabling owners to vote separately (i) on a takeover, and (ii) on selling the shares if a takeover takes place, is a clean way to downsize the pressure.
  2. Preventing structurally coercive bids, though restrictive, could also favour undistorted choice. Limiting bids to all-shares offers with a later same price freeze-out, could do, but is still worse than the previous solution, (intertemporal discount rate can`t be optimal for all shareholders).
  3. Actually, a blockholder or bidder sometimes is restricted to a previous ballot by other shareholders, on his capacity to vote his shares, which prevents some bidders to invest. With a poison pill, the vote is really on directors replacement.
  4. In case an undistorted choice system is in place, board should not have a power to veto a shareholders` vote, should not distort the outcome of that vote, nor block the takeover once it is approved. A poison pill is consistent, if a vote on it can be held, even with a system of enough written consent.

The case against or for the Veto

The first thing to be clarified is the perspective under which this topic is considered:

–         Target shareholders` perspective: ex post and ex ante agency costs are against the Board Veto, (BV). BV supporters argue against the efficient capital markets theory, and also point out that directors, given their insider information, are the best placed to decide on whether to accept and offer or not. They also think of veto as a bargaining tool; of excessive short-termism when takeover threat is real; and of compensation schemes as being a valid tool to correct managers`self interest in using the veto.

–         Target`s long term shareholders` perspective: those favouring board veto support the idea that laws should rather favour long-term shareholders, (although empirical evidence that takeover resistance has been positive for them, is not conclusive).

–         Total Shareholder`s wealth perspective: according to this, total corporate wealth including the bidder`s wealth should attract lawmakers. A transfer of a premium can`t be considered a net benefit, and the case of a rejection would bring into the equation the huge costs that failed bidders afford. This perspective does no favour the veto argument.

–         All corporate constituencies` perspective: other stakeholders` interests should be considered. This could justify a veto, but it is perhaps not the best way to protect stakeholders, and the doubt remains as to whether managers would defend them or their own interests, while using veto power.

ML, argues first, that poison pills allow managers not to manage an “always for sale” company, thus avoiding the related costs; second, he considers PB`s proposal is weak: a referendum is not needed, as a proxy fight option is always available; besides, directors have a duty to pursue the best interests of shareholders, and they are accountable for their actions before courts; moreover, a referendum should be strongly conditioned to be operative, (bids should be serious, not excessively conditional, approved by regulatory bodies, and so on).

Blockholder Disclosure: a case for transparency or for monitoring benefits?

November 9, 2012 1 comment

We refer in this post to the norm that in the USA and most other countries forces significant beneficial owners report their shareholdings. In particular, in the USA, any holder tresspassing a 5% threshold has a 10 day term to report that fact. Beneficial ownership is said to exist over securities over wich voting or investment power is held, including the power to dispose of it. As for ownership through derivatives, it is only counted when they confer the right to acquire beneficial ownership within 60 days.

The purpose of the ruling is to alert investors about potential changes in corporate control and provide them with the opportunity to evaluate their effect and to react accordingly. In what follows, we explain the controversy that has arisen in the las year about this, between academics –Bebchuk and others- and practitioners, -the law firm Wachtell, Lipton, Rosen and Katz-.

As for the concept, Wachtell, Lipton, Rosen and Katz made the point, in a 2011 letter addressed to the SEC, that cash-settled derivatives, share-parking and other “voting right and economic risk decoupling practices”, are not included. Thus, they propose economic risk holdings should also be included in the concept, because they allow the holder to exercise market control, even short positions, and at the end, they may eventually be settled in kind.

As for the 10 day delay, once the threshold is passed, WLRK suggest that it is used by many hedge funds, or other aggresive investors, to increase their holdings, so that valuable information is hidden from the public.They propose to shorten the period, as investors accumulating significant stakes are sophisticated ones, that do not need so much time, and they even suggest to introduce a “cooling-off period” equivalent to the disclosure lag, so that investors are prevented from increasing their holding in that period. Hedge funds often argue they need that lag to amass large enough holdings to force companies to take efficient actions, to the profit of all shareholders.

Bebchuk and Jackson first argue that the ten day lag was an explicit equilibrium tool between blockholders` interests and the need for disclosure. They afterwards argue about the costs of tightening the rules: given the free riding problem that affects the blockholder that tries to monitor a certain company, (which makes incumbent accountable and reduces agency costs and managerial slack), tightening the rules would diminish their incentives to do so. They provide references to empirical evidence regarding that latter effect of large blockholdings, and also argue that without large stakes the case of a proxy fight is reduced, as the benefits coming from their eventual existence. The ability to buy a large stake at prices before monitoring and engagement expectations are included, is critical for them to have incentives to incur in those costs. As for the benefits of tightening the rules: WLRK argue that the appropiation of part of the control premium by blockholders would be avoided. Bebchuk and Jackson counterargue that blockholders do not really control the company as a result of the ten day lag, but they still need to convince other shareholders to drive the company`s actions. Bebchuk and Jackson also argue against regulating isolated aspects of the balance between blockholders and management, without considering the broad picture, (for instance poison pills are commonly approved by state law in the USA).

On their response to the previous, WLRK argue that what they intend is to assure that there is no loophole to what the law tries to enforce, “transparency and disclosure”. If a large 25% stake can be accumulated before anything is broadcasted, what is the law for? Besides, they say, the law was not a balance between insiders and outsiders, the ten day lag was the recognition of some costs and administrative burden, not anymore existent, and the law aim was transparency, having failed in that purpose. Besides, they argue there is no evidence for the blockholders` monitoring benefits, (wealth creation in the long term), but only for short term price increases derived from the M&A option appearing, for instance. Moreover, institutional investors, rather than opportunistic hedge funds are to be credited for monitoring activities.

A fascinating debate, usual between Bebchuk and Lipton in the last decade, over this and other topics, that will for sure continue!

Hidden ownership and disclosure recommendations

November 3, 2012 1 comment

We can define Hidden Ownership as the situation of an economic agent having an economic interest over a certain share, over which he hasn`t got any control or voting right, not being the owner of the share. The derivative market is the tool with which this result is usually built, (a future contract, a call option, an equity swap are valid instruments for that).

Hidden owners may also negotiate with short traders in the transaction that they will vote the shares according to the long traders`preferences. In that case the long trader is a hidden and morphable owner. Morphable ownership also appears when the economic risk holder may assume he will be able to decide the sense of the vote of the subjacent shares, whether by agreement with the short trader or because the case is clear for him that the normal solution at the settlement date will be a share acquisition from the short trader, that would buy the shares then, or would have had the shares since the beginning, (imagine the case of an illiquid market for these shares).

The huge growth of derivative markets has led to a parallel increase in the number of decoupling (of economic and control interests) incidents, both empty voting (see our post dated October 7th 2012) and hidden ownership. In the case of a hidden owner, the bank facilitating the derivative usually becomes an empty voter, (hedging his position purchasing shares in the stock market). As the bank has no economic interest with the company, but a commercial interest in the customer, it can eventually accept to vote with the customers`preferences, this one becoming also a morphable owner. As derivatives are today mostly cash-settled, there is no limit to its amount, so that hidden ownership is now easier than it was.

The concern with decoupling is about efficiency, fairness, (decoupling is used by hedge funds, industries, but not by small investors), and regulation circumvention.

Known hidden and morphable ownership cases have been unveiled in Switzerland in 2007, when several companies saw large stakes being disclosed in a takeover hidden attempt; regulation only asked to disclose voting rights and physically settled options. Hu and Black unveil a huge number of cases, and analyse regulatory proposals, (“Equity and Debt Decoupling and Empty Voting II: Imprtance and Extensions”).

Since then a clear case is made for disclosure, pursuing the efficiency result that all shareholders know who is buying or selling, so that the price mechanism works well. For disclosure, Hu and Black propose:

–         Disclosure should involve voting and economic rights, from share od coupled assets (derivatives, share borrowing…), ownership,

–         Disclosure should involve both positive and negative economic interest,

–         Disclosure should involve share lending and borrowing,

–         Consistency of disclosure asset type obligation and types counted for thresholds,

–         Disclosure of empty voting,

As for hidden ownership, disclosure could be enough, as it will not be hidden anymore, and inefficient effects on pricing will not appear. Hu and Black also recommend that voting rights are passed on to the economic owner, as generally banks in a derivative contract are empty voters. This would prevent investors from keeping hidden ownership. Moreover, they recommend that economic owners vote directly, and not through the empty voter, (bank, broker, and so on), so as to avoid complexities and mistakes in the voting process.