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1. - - - - - - - - Chapter 20- - - - - - - - Corporate Governance and Performance ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 1

2. Corporate Governance Systems in the United States • Diffuse stock ownership • Limited liability public corporation • Diffuse ownership of voting equity shares • Large number of individual share owners ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 2

3. Requires little direct monitoring of individual firms by investors • Limited liability of investors • Diversification allows investors to ignore idiosyncratic risks of individual companies • Equity ownership shares actively traded • Commercial banks and insurance companies limited in their ability to hold large equity positions in individual companies ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 3

4. Contractual theory of the firm • Firm as network of actual and implicit contracts • Contracts specify roles of stakeholders and define their rights, obligations, and payoffs • Potential conflicts • Contracts unable to envisage many changes in conditions that develop • Participants may have personal goals • Separation of ownership and control • Operations of firm are conducted and controlled by managers without major stock ownerships • Conflicts of interest arise between owners and managers ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 4

5. Jensen and Meckling (1976) • Agency problem — divergence of interests between owners (the principal) and management (their agent) • Fractional firm ownership by managers can lead managers to work less and to consume excessive perquisites • Additional monitoring expenditures (agency costs) are required • Auditing systems • Bonding assurances • Organization systems ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 5

6. Divergent interests of stakeholders • Business firms must recognize wide range of expectations of diverse stakeholders • Business firms must recognize external influences — job safety, product safety, environmental impacts • Business firms must recognize wide range of stakeholders and external influences to achieve long-run value maximization ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 6

7. Internal Control Mechanisms • Shareholders elect board of directors to represent their interests • Problems of how all stakeholders can obtain representation of their views and interests have not been resolved • Public expectations look to board of directors to balance interests of all stakeholders ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 7

8. Campbell, Gillan, and Niden (1999) • Analyzed how shareholders used proxy mechanism in 1997 proxy season • Shareholder-proposal rules (Rule 14a-8) allow shareholders to include proposal and 500-word supporting statement in proxy materials • Sample of 287 social policy proposals and 582 corporate governance proposals at 394 companies • 43.3% of all proposals were considered for vote • Corporate governance proposals — 49.2% were voted on and 35.2% were either omitted or withdrawn • Social policy proposals — 31.4% were voted on and 61.6% were either omitted or withdrawn • Rule 14a-8 remains an important avenue for shareholders ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 8

9. Role of the Board of Directors • Views of role of monitoring board • Pro: In theory, monitoring by board of directors can deal with problems of corporate governance • Con: Boards have been ineffective • Board fails to recognize problems of firm • Board does not stand up to top officers • External control devices such as hostile takeovers have multiplied because of failure of boards ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 9

10. Composition of the board • Role of outside directors • Outside directors — directors who neither work for the corporation nor have extensive dealings with company • Outside directors play larger role in monitoring management than inside directors • Fama (1980) • Outside directors enhance viability of board in achieving low-cost internal transfers of control • Lower probability of collusion with top management • Fama and Jensen (1983a) — outside directors have incentives to protect and develop reputation as experts in decision control ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 10

11. Weisbach (1988) • Tested hypothesis that inside and outside directors behave differently in monitoring top management • Outsider-dominated boards more likely to remove CEO • Replacement of CEO • Statistically significant inverse relation between firm's market-adjusted share performance in a year and likelihood of subsequent change in CEO • For outsider-dominated boards, responsiveness of removal decision to stock market performance is three times larger than for other board types • Replacement decision takes place relatively quickly ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 11

12. Rosenstein and Wyatt (1990) — CAR for total sample was significantly positive when company appointed outside directors • Borokhovich, Parrino, and Trapani (1996) • Positive relation between proportion of outside directors and likelihood that outsider is appointed CEO • Market views appointment of outsider to CEO position more favorably than appointment of insider ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 12

13. Compensation of board members • Well-structured compensation systems may motivate directors • Director stock ownership better aligns director interests with stockholders • Stock ownership requirements for directors and/or payment of part or all of directors' annual retainer in stock and stock options • Finance directors' retirements with stock • Studies find directors of top-performing companies hold greater number of shares than do counterparts at poor-performing firms • Critics argue that compensation should not be motivating factor ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 13

14. Evaluating a board of directors • Business Week (11/25/96) • Rated boards by how close they came to meeting these recommendations: • Evaluate CEO performance annually • Link CEO pay to clear performance criteria • Review and evaluate strategic and operating plans • Require significant stock ownership and compensate directors in stock • No more than three insiders • Require election each year and mandatory retirement at 70 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 14

15. Key committees should be composed of outside directors • Limits on number of boards and ban on interlocking directorships • Disqualify (from board) anyone receiving fees from company • Some pension funds and mutual funds judge boards by stock market performance of their companies — a "blinkered view" • Millstein and MacAvoy (1998) • Better board rating (based on either board independence or performance) associated with higher spread of return on invested capital (ROIC) over cost of capital (WACC) ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 15

16. Ownership Concentration • Equity ownership by managers must balance • Convergence or alignment of interests • Entrenchment considerations — managerial ownership and control of voting rights may allow pursuit of self-interest ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 16

17. Ownership and performance • Stulz (1988) • Model in which at low levels of management ownership, increased equity holdings improve convergence — enhance firm value • At higher levels of insider ownership, managerial entrenchment prevents takeovers — decrease firm value ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 17

18. Morck, Schleifer, and Vishny (MSV) (1988) • Study based on 1980 data • Performance (measured by q-ratio) related to management or insider ownership percentages • Ownership concentration increased from 0 to 5% • Performance improved • Alignment-of-interest effect • Direction of causality may be reversed — high performance firms more likely to give managers stock bonuses • High performance firms may have substantial intangible assets that require greater ownership concentrations to induce proper use of these assets ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 18

19. Ownership concentration in range 5% to 25% • Performance deteriorated • Management entrenchment dampens performance • Ownership concentration above 25% • Performance improved but slowly • Incremental entrenchment effects attenuated ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 19

20. McConnell and Servaes (MS) (1990) • Replicate MSV study using 1976 and 1986 data • For 1976, relationship between ownership concentration and performance relatively flat with moderate convergence of interest effect up to 50%, after which curve flattens and then declines moderately • For 1986, relationship curve rises relatively sharply to 40%, after which it is relatively flat to 50% followed by sharp decline • Leverage, institutional ownership, R&D expenditures, and advertising expenditures do not change initial findings ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 20

21. Cho (1998) • Replicates MSV patterns using ordinary least square regressions and 1991 data • Tests for endogenous ownership structure • Finds that corporate value affects ownership structure, but not reverse • Bristow (1998) • Sample of consistently derived insider holdings on 4,000 firms during 1986-95 • Relationship between management ownership and performance varies for each of the ten years ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 21

22. Economic variables influence ownership-performance relationship • Relative growth rates of industries • Differences in demand-supply relationships among industries • Relative value change patterns among industries and firms within them • Stock price movements • Interpretations of diverse data patterns • May reflect economic identification problem discussed by Cho • True relationship may be Demsetz-Lehn theory of no relationship between ownership level and performance ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 22

23. Holderness, Kroszner, and Sheehan (1999) • Percentage of managerial equity ownership • Mean increased from 12.9% in 1935 to 21.1% in 1995 • Median increased from 6.5% in 1935 to 14.4% in 1995 • Doubling of managerial ownership may imply improvement in corporate governance in U.S. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 23

24. Managerial ownership and bond returns — Bagnani, Milonas, Saunders, and Travlos (1994) • No relation between bond returns and managerial ownership below 5% • Positive relation for managerial ownership between 5% and 25% • Increased incentives for managers to act in shareholders' interest, taking risks that are potentially harmful to bondholders • Rational bondholders required higher returns ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 24

25. Weak negative relation for ownership above 25% • Managers become more risk averse • Managers have high stake in firm — greater incentives to protect their private benefits and objectives • Managers' interest more aligned with bondholders — lower bond premia ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 25

26. Financial policy and ownership concentration • Share repurchases financed by debt • Insider group does not tender its shares in repurchases — percentage equity shares increased • Increased convergence of interest effect • Incentive effects of high management ownership percentages performed positive role in LBOs and MBOs ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 26

27. Safieddine and Titman (1999) • Sample of 573 firms that successfully resisted takeover attempts during 1982-1991 • Effects on leverage • Increased leverage is one form of defensive strategy • In 207 firms, median leverage ratio increased from 60% to 71.5% • Corporate restructuring activity • Turnover of top management during three-year window • 30% for low leverage increasing group • 37% for higher leverage increasing firms • Turnover of top management after takeover attempts • 44% replaced in hostile takeover attempts • 29% replaced in friendly takeover attempts ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 27

28. Operating performance improves and long-run post-termination performance of leverage-increasing targets superior to benchmark • Returns grow by about 55% after five years • Level of returns same as what would have been realized by accepting takeover offer • Manager's behavior of leverage-increasing target firms consistent with long-term interest of their shareholders • Strong long-term abnormal stock price performance despite initial drop at takeover termination announcement • Associated productivity improvements ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 28

29. Amihud, Lev, and Travlos (1990) • Sample of firms that made cash acquisitions of over $10 million of other firms during 1981-1983 • Cash acquisitions are associated with significantly larger insider ownership levels than stock financed acquisitions ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 29

30. Executive Compensation • Conflict of interest between owners and managers reduced if executive compensation plans more tightly related pay to performance ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 30

31. Executive compensation and changes in value of firm • Jensen and Murphy (1990) • Executive pay changes only $3 for $1,000 change in firm wealth — elasticity of 0.3% • Low elasticity indicates executive pay is not closely linked to performance • But low elasticity partially explained by large value of firm in relation to executive compensation ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 31

32. Haubrich (1994) — derived Jensen-Murphy results using principal-agent theory models • Schleifer and Vishny (1995) — Jensen-Murphy relationship would generate large swings in executive wealth and would require considerable risk tolerance for executives ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 32

33. Executive compensation and firm's corporate governance — Core, Holthausen, and Larcker (1999) • Sample of 495 observations for 205 publicly traded U.S. firms during 1982-1984 • Board of director characteristics and ownership structure significantly related to CEO compensation • CEO compensation higher • CEO was also board chair • Board was larger • Greater percentage of outside directors appointed by CEO • More outside directors considered 'gray' • Outside directors older and served on more than three other boards ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 33

34. CEO compensation lower • Greater percentage of inside directors in board • Lower CEO's ownership stake • Existence of non-CEO internal board members or external blockholders who owned at least 5% of equity • Significant negative relationship between compensation predicted by board and ownership variables and subsequent firm operating and market performance • Board and ownership variables are proxies for effectiveness of firm's governance structure • CEOs of firms with greater agency problems were able to obtain higher compensation • Firms with greater agency problems perform worse ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 34

35. Executive compensation and performance measures • Criticism that compensation had been based on accounting measures rather than stock market-based performance measures • Rappaport (1986) • Early executive compensation performance plans were market based • In 1970s, performance measures for granting options shifted to accounting-based measures • In recent years, performance is moving to market-based measures ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 35

36. Other proposals for improved pay-performance policies • Limit base salaries of top executives • Bonus and stock option plans based on stock appreciation • Stock appreciation benchmarks should consider • Close competitors • Wider peer group • Broader stock market indexes ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 36

37. Stock options based on premium of 10-20% over current market and should not be repriced • Company loan programs should enable top executives to buy substantial amounts of firm's stock • Directors should be paid mainly in stock with minimum specified holding periods ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 37

38. Outside Control Mechanisms • Stock prices and top management changes • Warner, Watts, and Wruck (1988) • Poor stock price performance likely to result in increased rate of management turnover • Evidence of several internal control mechanisms — monitoring by large blockholders, competition from other managers, discipline by board ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 38

39. Denis and Denis (1995) • Announcement of changes in management • Forced resignations: Positive 1.5% (significant) • Normal retirements: Insignificant effects • Forced top management changes • Preceded by significantly large operating performance declines and followed by significant improvements • Associated with significant downsizing measured by declines in employment, capital expenditures, total assets • Improvements did not result from effective board monitoring ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 39

40. 13% of 853 sample were forced changes • Two-thirds of forced resignations associated with blockholder pressure, financial distress, shareholder lawsuits, and takeover attempts • 56% of firms with forced changes became target of corporate control activity • Internal control mechanisms were inadequate; required pressure from external corporate control markets ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 40

41. Role of stock market • Schleifer and Vishny (1997) survey does not develop potential role of stock market and security price movements in disciplining managers • Security price movements provide scorecard measuring management performance • Bad scores on stock market increase likelihood of managerial turnover ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 41

42. Public pension funds • Public pension funds have ability and size to become significant factors in corporate governance • California Public Employees' Retirement System (CALPERS) publicly announced names of companies that failed to negotiate adoption of corporate reforms • World’s largest pension plan, TIAA-CREF, encourages companies to have independent, diverse boards ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 42

43. Carleton, Nelson, and Weisbach (1998) • Described negotiation process between TIAA-CREF and target firms on governance issues • All firms agreed to institute confidential voting • Most firms contacted added women or minorities to board • Most firms that were asked to limit use of blank check preferred stock as antitakeover defense complied ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 43

44. Wahal (1996) • Nine activist pension funds in period 1987-1993 • Activist proposals shifted from takeover-related proxy proposals in late 1980s to governance-related proposals in 1990s • Takeover-related proxy proposals — poison pills, greenmail, antitakeover provisions • Governance-related targeting — golden parachutes, board composition, compensation ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 44

45. Abnormal returns • Zero average abnormal returns for shareholder proposals • Small positive abnormal returns for attempts to influence target firms in using shareholder proposals (nonproxy targeting) • No significant long-term improvement in either stock price movements or accounting measures in post-targeting period ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 45

46. Strickland, Wiles, and Zenner (1996) • Studied United Shareholders Association (USA) from 1986 to 1993 • USA developed a Target 50 list of firms • USA successfully negotiated corporate governance changes in 53 proposals before inclusion in proxy statements • Abnormal return to target firm = 0.9% at announcement of negotiated agreements — wealth increase of $1.3 billion • USA effective when target firm was poor performer with high institutional ownership ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 46

47. Multiple Control Mechanisms(Agrawal and Knoeber, 1996) • Sample of 400 largest firms • Consider seven control mechanisms • Insider shareholdings • Outside representation on board • Debt policy • Activity in corporate control market ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 47

48. Institutional shareholdings • Shareholdings of large blockholders • Managerial labor market • Firm performance measured by Tobin's q • Results • Considering influence of each control mechanism separately — first four control mechanisms statistically related to firm performance • Considering all mechanisms together, but not within simultaneous equation system — influence of insider shareholdings drops out ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 48

49. Considering all mechanisms together and using simultaneous equation system — only negative effect on firm performance from outside representation remains • Concluded that control mechanisms chosen optimally except for use of outsiders on boards (most other studies find positive benefits from use of outsiders) ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 49

50. Proxy Contests • Background • Definition: Attempts by dissident groups of shareholders to obtain representation on board of directors • Success of proxy contests • Most fail to get majority representation • Better measure of success: Whether dissident group gains at least two members on board — one to make motion, another to second it ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 50