A Survey at Corporate Governance (1997)

Corporate governance is concerned with how financial institutions ensure that their money is returned
to them. Corporate governance mechanisms are economic and legal institutions that can be changed
through a democratic process. Market competition, in theory, could force firms to reduce costs and, as
part of implementing several rules, such as corporate governance mechanisms, to be able to raise
external capital at the lowest possible cost. However, in the real world, capital flows are not perfect, and
those who provide capital must be confident that their money will be returned. And this is very
expensive. It's known as agency cost, and it stems from the fact that the firm's shareholders and
managers are not the same person.

1. The Agency Problem

Because the owner of the firm is not the same person who manages the firm, contracts must be made
to ensure that the manager does not take the money and run. In exchange for compensation, the owner
hires the manager to invest his money. So they sign the contract; however, because this contract cannot
cover all possible future scenarios (the problem of incomplete contracts), the shareholder must grant
the manager some control rights. Because shareholders are dispersed, they may choose not to monitor
the manager (free rider problem), leaving too much discretionary power over the residual rights. This
may result in managerial expropriation. Investors are not stupid; if these scenarios were to occur, they
would not invest in the company at all. That is why, in order to attract investors, managers impose some
constraints on themselves. Even with these constraints, the situation created is worse than if the
manager owned the company. There would be no agency problem if the manager owned the firm
because he is incentivized to make the best investments with his money. But if it's someone else's
money, he won't be as cautious; he might take on a project that makes him $10 but costs shareholders
$20. Because managers are more concerned with their own wealth than with the company,
shareholders can "bribe" managers to do or not do something. Paying him with a golden parachute after
persuading him to let the company take over, and so on. However, this is not very common because
they signed a duty of loyalty contract with the shareholders to avoid taking on value-decreasing
projects. This contract is required to ensure that shareholders are not constantly threatened by
managers (if you do not accept this, I will undertake an even more damaging project). So, managers are
left with massive residual control rights, allowing them to pursue self-interested projects. To address
this issue, shareholders can draught effective long-term incentive contracts. Stock options,
performance-based bonuses, and so on. These may be beneficial, but managers can still use these
incentives to create self-dealing. The evidence for agency costs comes primarily from event studies, but
every time the stock price falls as a result of a managerial announcement, shareholders suffer. Jensen's
free cash flow theory. Managers are concerned with expansion and diversification.

2. Financing Absent Governance

External financing conundrum: why would investors give their money to managers who have complete
control over what they do with it? Building a reputation: managers repay investors in order to receive
more funds in the future. Investor optimism: When investors are excited about new companies, they
invest their money in them solely for the short-term returns from stock price appreciation. Ponzi
schemes, pyramid games, and so on. However, these two explanations are insufficient to justify the
amount of external financing.

3. Legal Protection

Shareholders have certain rights if managers violate the contract, the most important of which is
shareholder voting. Managers, on the other hand, try to make it difficult for shareholders to vote; this is
especially true when the shareholder base is dispersed. Because shareholders' investments are
immediately sunk, it is extremely difficult for them to compel managers to return returns. Shareholders
require at least some rights in order to defend themselves against self-interested managers. Creditors
have legal protection as well; they have the right to liquidate the company if it defaults, for example.
However, creditors must fight hard when a company goes bankrupt because there are many creditors
who want their money back. It is even more difficult if there are large, institutional investors; it could
take years to divide the firm's assets, making debt a less appealing financing method. However, because
bankruptcy is not a preferred scenario for the managers, creditors' rights are enforced (in a very costly
and inefficient way though).

4. Main Investors

If legal protection is insufficient to protect small shareholders from managerial expropriation, they can
go big. Large investors do not require as many legal rights because they have both the power and the
incentive to exert their will on managers. Concentrated ownership can serve as a level of legal
protection. Having large investors, on the other hand, has its drawbacks.

Large shareholders have the power and incentive to monitor management, and the free rider problem
has been addressed. Of course, some legal protection is required to allow large shareholders to exercise
their rights, such as voting. Minority shareholders must be well-protected in order to participate in
developed, small-investor capital markets.

Takeovers: In a hostile takeover, an investor makes a bid to the target firm's dispersed shareholders and,
if accepted, gains control of the firm. Takeovers are regarded as crucial corporate mechanisms without
which managerial discretion cannot be effectively controlled. They are costly, may include agency costs
(overbidding), and necessitate a liquid capital market.

Large Creditors: Large banks are regarded as active investors. Their power stems from the variety of
control rights they receive if the company goes bankrupt, as well as the fact that they lend on a short-
term basis, requiring borrowers to return on a regular basis. Creditors receive "only" the standard
returns in the form of interest payments. As a result, large creditors have significant cash flow rights as
well as the authority to make major decisions in the firm. Legal rights are essential - bank governance is
sound only in countries with a high-level legal system that provides creditors with rights.

Large investors reduce the burden on a country's legal system, so they are more common in countries
with less developed legal systems than the United States.

5. What are the costs of having a large number of investors?

Large investors represent their own interests, which may differ from those of employees and other
investors. Because they are only concerned with increasing their own wealth, the possibility of
expropriation is stronger in firms where other stakeholders have firm-specific investments as well. They
may preferentially treat themselves at the expense of other investors. If control and cash flow rights are
not distributed in a 1:1 ratio, this problem can be severe. They may be overly soft negotiators; they may
also have agency issues; they may fail to terminate unprofitable projects; or they simply prefer
maximum control over maximum wealth.

6. Particular Governance Arrangements

So they talked about the role of legal institutions and concentrated ownership, and now these are the
specific contractual mechanisms for dealing with agency problems.

Debt vs. equity: For outside investors, debt offers better protection than equity because creditors' rights
are clearer and violations of those rights are easier to prove in court. How do you raise external equity in
a country where investors have no rights? Investors should hope for a change in reputation in the short
run and a change in legal rights in the long run.
LBOs have concentrated equity ownership by managers and the PE firm, as well as concentrated debt
ownership by banks. As a result, effective monitoring is achieved, and the debt overhang motivation
ensures that the firm uses its resources as efficiently as possible.

Cooperatives and State Ownership: If concentrated ownership isn't ideal, cooperatives might be a better
option. It isn't as profit-driven as concentrated ownership (childcare, healthcare, etc.). The same is true
for state ownership: where monopoly power, externalities, or distributional issues are a concern, state
ownership may be the best option. Privatization arose as a result of SOEs' inefficiency. To summarise,
addressing the agency problem requires a combination of large investors and at least some legal rights.