Corporate Governance & Social Responsibility
Lecture 1: Introduction
1. Agency Problem
The Agency Problem occurs between a Principal and an Agent, whose goal is the same: Maximize their own utility. The
agency problem arises when an agent acts on behalf of a principle, while his actions may not be in the best interest of the
principal. This gives rise to Moral Hazard which entails that, once a contract is signed, it may be in the interest of the agent
to behave badly or less responsibly. Some examples of moral hazard can be insufficient effort from the agent, entrenchment
(i.e. extravagant investment), self-dealing, lack of transparency, accounting manipulations, etc.
But how is it possible to mitigate the principal-agent problem? Through Complete Contracts, which should specify the two
following issues:
- What the managers must do in each future contingency of the world
- What the distribution of profits will be in each contingency
However, according to Williamson (1984), it is not possible to have complete contracts in practice, as:
- It is impossible to predict all future contingencies of the world
- Such contracts would be too complex to write
- They would be difficult or even impossible to monitor and reinforce by outsiders such as a court of law
On the other hand, a necessary condition for moral hazard to exist and for complete contracts to be an impossibility, is the
existence of Asymmetric Information. Asymmetric information occurs as usually the agent has more information, and the
principal cannot keep track of the agent’s actions at all times due to the costs.
Jensen & Meckling (1976) studied the principle-agent problem in the context of separation of ownership and control.
As the firms grows, it sells (1-a)% of the shares.
For the owner-manager there is no conflict of interest arising from non-pecuniary (non-economic) benefits. He has a maximum
incentive to work harder as the additional revenue will always be accrued by him. On the other hand, the agent only has a%
of the shares, and this is when the conflict of interest starts. The agent has less incentive to work harder as if the firms grows,
the fruits will go to the shareholders.
The difference between the principal and the agent is that the principal has the required funds but is not qualified to run the
firms, whereas the agent know how to run the firms but has no funds to finance its operations.
Agency costs are the sum of three different costs:
- Monitoring costs: consist of the principal observing the agent and keeping a record of the agent’s behavior. The
principal also intervenes in various ways to constraint the agent’s behavior and to avoid unwanted actions.
- Bonding Costs are the costs incurred by the agent in order to signal credibly to the principal that he will act in the
interest of the principal, for instance, by buying shares of the firm.
- Residual Loss is incurred by the principal, as the agent may not make the decision that maximize the firm value.
1.1 Forms of Agency Problems
Agency problems come in two forms:
1. Perquisites is the consumption of the management. The benefits are accrued by the management, whereas the costs
are borne by the shareholders. E.g. CEO mansions, giving jobs to family, corporate jets.
2. Empire Building is the free cash flow problem, which arises when the management is pursuing growth rather than
shareholder maximization. The management should invest only in projects with positive NPV, as a negative NPV
may destroy shareholder value. E.g. buying other firms whose PVGO is negative.
1.2 Classical Agency Problem vs Expropriation of Minority Shareholders
,Most stock exchange listed firms have large shareholders that have a substantial degree of control over the firm affairs.
There are two different types of shareholders: (1) controlling shareholders, and (2) minority shareholders.
Expropriation of the minority shareholders by the large shareholders can be in the form of:
1. Tunneling
Example: Large shareholders hold 51% of Firm A and 100% of Firm B. Firm A is selling assets at a deflated price to
firm B.
Firm A loss = $1 → Large shareholder loss in firm A = $0.51 → Minority shareholder loss = $0.49
Firm B gain = $1 → Large shareholder gain in firm B = $1
Net gain = $0.49
2. Transfer Pricing: overcharging for the services and products.
3. Nepotism
- Appointing family members to the top management positions
- Suboptimal allocation of human capital
- Managerial entrenchment: protecting against hostile takeovers and internal disciplinary actions
4. Infighting
- Fight among the large shareholders
- Typically between family members
Lecture 2: Executive Compensation
In this lecture we will look at executive pay structures as well as pay and incentives. First, we recap the managerial incentives:
1. Managerial Incentives
We look at the incentives between the manager and the shareholders (also the risk-bearer).
The shareholder holds residual claim to the firm assets, and he has the right to sell his stake in the firm. Further, the
shareholder is able to diversify.
On the other hand, for the manager, his human capital is tightly tied to the firm, and he is not able to diversify. Therefore, he
earns a rent for his service.
We have talked about asymmetric information, and how it leads to imperfect monitoring. This leads to a situation in which
the manager shirks (neglects), which leads to the shareholders paying the manager less. As a result, the manager has less
incentive to work and inform the principal about what’s going on at the firm, leading once again to imperfect monitoring.
The solution for this is proper incentives. Therefore, we will look at how executive compensation should be designed.
2. Executive Compensation
, Executive compensation comes in several forms:
- Base salary: typically determined through benchmarking (industry and size).
- Bonus: short-term incentive, usually cash, based on performance measures and standards. Most firms use more than
one performance measure. Some examples of financial performance are earnings, EBIT, sales, share price; whereas
for operational performance, customer satisfaction and product development. The issue with accounting measures is
that they are backward looking and quite easy to manipulate. Regarding stock prices, they are harder to manipulate
and more forward-looking. However, the stock price does not only reflect managerial effort, but also on the risk
exposure of the firm.
- Long-term incentive plan: stock options, restricted stocks, or cash, sabbaticals, vacation.
Stock options can be “bad” as they induce too much risk-taking. Some common features of stock options are: fixed
strike price, expiration in 10 years, vesting after 3 years, strike price is equal to the grant-date stock price (i.e. options
are granted at-the-money). Therefore, the stock options give incentive to the executive to focus on long-term
performance. If we look at the current value of the stock options, it is likely an overstatement of the perceived value
to the manager, as the manager cannot trade, and cannot hedge the risk. If the manager leaves prior to exercise, then
the options are valueless.
On the other hand, restricted stock cannot be traded but it can be sold after a number of years (usually 3-5 years).
- Retirement plan
- Insurance plan
We focus on the incentive components, bonus and long-term incentive plan. One sub-component of the long-term plan is the
equity-based compensation which includes the stock options and restricted stocks. Most of the increase in compensations is
due to equity pay.
There are two components to the executive compensation schemes:
1. The Stick: This is where the BoD fires executives who are not performing. This is measured by executive turnover
and firm performance. Bad stock price performance is usually associated with executive turnover. However this view
is limited, as the stock price is not fully based on the executives’ performance.
2. The Carrot: The executive is rewarded on a pay-for-performance basis. The optimal contract for managers is
based on principal-agent models, where their effort is rewarded, but they have to rely on some performance measures
as a signal of their effort.
There is usually a compensation committee (outside directors) which sets the executive pay. However, directors are often
unwilling to challenge the CEO due to friendship ties and value connections, and also because they want to avoid creating a
bad atmosphere. The director who disagrees with the majority is usually asked to resign, thus, criticism is often only voiced
in case of serious trouble.
2.1 Empirically Determining the Pay-Performance
The sensitivity of executive pay to performance is typically measured by running a regression on changes of executive wealth
and the change in firm value.
The beta is the average pay-performance sensitivity. However, the issue is that we need
to control for many potentially confounding factors.
If we do not condition based on firm size, we see a negative relationship between stock
performance and executive pay. This is because firm size is correlated with both the stock
performance and executive pay. Thus, it makes it difficult to get a correct estimation of
beta.
Small firms, on average, exhibit higher stock returns because the shareholders want to be
compensated for the higher risk that is associated with small firms.
