Law Econ Public Companies - Class 1 2 - Winter 2022

Jochen Bigus & Andreas Engert
The law and economics of public

companies
Winter term 2022

Introduction
Aim of the course
 Interdisciplinary course: insights from law and economics on the ways large
companies are “governed” and interact with capital markets
 For business and econ students: Understand the law better
 For law students : Gain a critical outside perspective on law, regulation and
policy (“beyond black letter law”)
 Understand the views of others trained in law or business/economics
 Find a captivating research topic
 Learn something about the world
2
Introduction
Introducing ourselves (Jochen Bigus)
 1994: Diploma in Business Administration, Freie Universität Berlin
 1998: Dr. rer. pol., thesis on lender conflicts
 2002: Habilitation, thesis on venture capital
 2003–2007: Professor of International Accounting at University of Osnabrück
 2007–2011: Professor of Financial Accounting at University of Bern,

Switzerland
 Since 2011: Professor of Management Accounting at Freie Universität
 Areas of interest:
• Corporate Finance and Financial Accounting, esp. with private firms
• Auditor Liability
• Law and economics
3
Introduction
Introducing ourselves (Andreas Engert)
 1997, 1999: State exams in Tübingen
 2000: Master of Laws at the University of Chicago
 2003: Dr. jur., thesis on lender liability/debtor governance
 2008: Habilitation, thesis on capital market efficiency and the law of

investment funds
 2010–2019: Professor of law at University of Mannheim
 Since 2019: Professor of law at Freie Universität
 Areas of interest:
• Private law: contracts, corporations, insolvency
• Financial market regulation
• Law and economics
4
Introduction
Modus operandi
 CoViD rules
• No masks required in class if (1) you have checked in on your seat, (2) we
keep the social distance of 1.5 meters, (3) all of us respect “3G”
• Airing every 45 minutes
 The course applies concepts from economics and corporate finance to selected
legal issues in corporation and securities law
 Often no single correct answer but an informed discussion
 Reading materials on Blackboard—the “required” readings are, well, required
 Do participate in classroom discussions! Do not hesitate to ask questions!
This is a challenging course. Understanding the basic ideas is more important than
detail. Engaging with the topics is the best way to study for this course.
5
Introduction
Credits & exams

 Regular attendance a necessary requirement to obtain credit
 FACTS students enrolled at Freie Universität (not exchange students)
• Oral exams on 16 December 2022
• Don’t worry but don’t start preparing 2 days ahead; again, participating
actively in the course is the best way to do well in the exam
 Law students from Freie Universität in “thematische Vertiefung” (who take
the course as their seminar)
• Limited admission; apply at sekrengert@zedat.fu-berlin.de by 30 Oct. 2022
• Write 15-pages paper on topic of choice approved by Professor Engert,
deadline 6 February 2023; guidelines at https://ogy.de/t7ni
 All other students (other law students, exchange students from business or
other majors)
• Two reaction papers, each 8,000–12,000 characters, in English
• Strict deadline: 18 December 2022; sekrengert@zedat.fu-berlin.de
 A 0.3 grade bonus for the best 20% students in classroom discussion 6
Introduction
Corporate law & economics textbooks
 Kraakman et al., The Anatomy of Corporate Law, A Comparative and

Functional Approach, 3d ed., Oxford, Oxford University Press, 2017
(around € 29)
Emphasis on comparative perspective, less on economic background
 Easterbrook/Fischel, The Economic Structure of Corporate Law, Cambridge
(Mass.), Harvard University Press, 1991 (around € 35)
A standard treatise but somewhat dated and only on US law
Unfortunately, there is no textbook that matches the content of the course. You can
rely on the slides and assigned readings. 7
Introduction
Resources on German law in English
• The Ministry of Justice (gesetze-im-internet.de) provides a translation of

certain statutes, such as the Civil Code (BGB), the Limited Liability
Companies Act (GmbHG) and the Insolvency Act (InsO).
• The Federal Financial Supervisory Authority (BaFin, at bafin.de) has
translations of securities and financial market legislation, such as the
Takeover Act (WpÜG).
• Electronic journal in English (with e-mail notification) on German and
European law: germanlawjournal.com
8
Introduction
Structure of the course

• Sessions 1 & 2: corporate governance, capital market efficiency
• Sessions 3–5: disclosure duties (theory, primary & secondary markets)
• Session 6: Insider trading
• Session 7: Market for corporate control
• Session 8: Going private
• Session 9: Determinants of capital market development and wrap-up
9
Classes 1 & 2
Corporate governance
10
What is corporate governance?
The origin of “corporate governance” (1)
• Origin of the term in the US in the 1970s(1)

̶ First appearance in the mid-1970s
̶ Context 1: bribery of foreign officials by US corporations (Foreign Corrupt
Practices Act 1977; OECD Anti-Bribery Convention 1997/1999)
̶ Context 2: (alleged) lack of social and environmental responsibility of US
corporations(2)
̶ Context 3: (alleged) lack of accountability of management to
shareholders
• Common denominator: making management of large public corporations with
dispersed shareholders more accountable (“managerialist corporation”)
• The term was adopted internationally in the 1990s, including in Germany
(1) Cheffins, The History of Corporate Governance, in: Oxford Handbook of Corporate
Governance, 2014, pp. 46 et seq. 11
(2) Cf. Nader/Green/Seligman, Taming the Giant Corporation, 1976
What is corporate governance?
Definitions of “corporate governance”

Shleifer/Vishny (1997):
“Corporate Governance deals with the ways in which suppliers of finance to corporations
assure themselves of getting a return on their investment.”
Drukarczyk/Schmidt (1998)(1):
“[N]etwork of arrangements and rules aimed at maximizing total market value of the firm”
Tirole (2001):
“I will, perhaps unconventionally for an economist, define corporate governance as the design
of institutions that induce or force management to internalize the welfare of stakeholders. The
provision of managerial incentives and the design of a control structure must account for their
impact on the utilities of all stakeholders (natural stakeholders and investors) in order to,
respectively, induce or force internalization.”
Note what is common to all these definitions: (1) corporate governance is more
than just law (“ways”, “arrangements”, etc.); (2) it is defined by its
function/objective (“getting a return”, “maximizing total market value”, etc.)
(1) Lenders as a Force of Corporate Governance, in: Hopt (ed.), Comparative Corporate Governance:
The State of the Art and Emerging Research, 1998, 759, 760
Classes 1 & 2
Section 1: Theory of the firm
13
Theory of the firm
A question worth a Nobel prize
Coase (1937):
“Our task is to attempt to discover why a firm emerges at all in a specialised exchange
economy. […]
The main reason why it is profitable to establish a firm would seem to be that there is a cost of
using the price mechanism. The most obvious cost of ‘organising’ production through the price
mechanism is that of discovering what the relevant prices are. […] The costs of negotiating and
concluding a separate contract for each exchange transaction which takes place on a market
must also be taken into account. […] A factor of production (or the owner thereof) does not have
to make a series of contracts with the factors with whom he is cooperating within the firm […]
For this series of contracts is substituted one. […] The contract is one whereby the factor, for a
certain remuneration (which may be fixed or fluctuating), agrees to obey the directions of the
entrepreneur within certain limits.”
The questions raised by Coase keep economists busy until today: What is a firm?
Why do firms exist in a market economy? 14
Theory of the firm
The firm as consisting only of contracts

• How do (many) lawyers think about firms?
̶ “Organizational law” (corporation law) as different from contract: creating
a distinct new entity, often a “legal person”
̶ “Association as a real person” (reale Verbandspersönlichkeit, von
Gierke, 1841–1921), organ theory vs. representation theory (Savigny,
1779–1861)
̶ The corporation as an institution in the public interest?
(Can the law permit shareholders to liquidate Deutsche Bank at will?(1))
• In marked contrast, the nexus-of-contracts view of the firm holds that “[t]he
private corporation or firm is simply one form of legal fiction which serves as a
nexus for contracting relationships […] The firm is not an individual.”(2)
• The legal and economic views can be compatible: legal (fictitious) entities as a
useful legal construct(3) but only the interests of individuals matter
 in this sense, even corporation law is “just contract”
(1) Rathenau, Vom Aktienwesen, 1917 (2) Jensen/Meckling (1976), p. 311 15
(3) Cf. Hansmann/Kraakman, The Essential Role of Organizational Law, Yale L.J. 110 (2000), 387
Theory of the firm
The firm as a nexus of contracts: the team

production model of Alchian/Demsetz (1)
• If firm consists only of contracts then what makes it different from the market?
• Alchian/Demsetz (1972): team production
̶ More than one input needed
̶ Several owners of inputs (team members)
̶ Contribution of inputs to outputs not separable
̶ Examples: “Two men jointly lift heavy cargo into trucks”; Airbus produces
airplanes; a university provides education and scholarship
• The intuitive solution: organize the team as a partnership where each partner
receives a share of the output (sales revenue)
• This conjures up an incentive/collective action problem: shirking, free riding
̶ 10 team members should contribute inputs worth €10 to produce total
output €150 with equal sharing  withholding one’s input saves €10 and
costs only €1.50 in revenue share (if marginal productivity were constant)
̶ Examples: take extra breaks; save effort; consume perks; etc. 16
Theory of the firm

• Why are shirkers not excluded or penalized?
̶ Information asymmetry: monitoring other team members is costly; inputs
are often hard to evaluate (e.g., engineering an airplane)
̶ Conflicts are costly to individual team members
 Penalizing shirkers poses a second-order collective action problem
Alchian/Demsetz (1972), pp. 780–781:

“In a university, the faculty use office telephones, paper, and mail for personal uses beyond
strict university productivity. […] Pay is lower in pecuniary terms and higher in leisure,
conveniences, and ease of work. But still every person would prefer to see detection made
more effective (if it were somehow possible to monitor costlessly) so that he, as part of the now
more effectively producing team, could thereby realize a higher pecuniary pay and less leisure.”
Does competition between teams solve the problem? For instance, competition of
firms in product markets? 17
Theory of the firm

The team as a network of contracts The firm as a nexus of contracts
The “nexus-of-contracts view” is often used to mean both (1) that the firm consists
only of contracts and (2) that the firm (owner) is the central party to all contracts 18
Theory of the firm

• Sed quis custodiet ipsos custodes(1)? Who will monitor the monitor?
• The ingenious solution of the capitalist firm (according to Alchian/Demsetz):
the central party becomes the “residual owner” of the team’s output
̶ Owner pays team members fixed wages
̶ Owner can keep the output net of fixed wages, i.e. the profit (“residual”)
• Why would team members content themselves with fixed wages and leave
profits to the owner?
̶ Owner has perfect incentives for cost-efficient monitoring
̶ In a competitive market, owners attract team members by paying wages
equal to marginal productivity (under optimal monitoring)
̶  In the long run, owners earn only the cost of efficient monitoring as
profits
(1) Juvenal, Satire VI, line 346-347 19
Theory of the firm

• The owner of the capitalist firm:

̶ Central party to all contracts (“nexus of contracts”)
̶ Residual claimant
̶ Right to sell “the firm”, i.e. the position as central party
Alchian/Demsetz (1972), pp. 783:

“contractual organization of inputs, known as the classical capitalist firms with (a) joint input
production, (b) several input owners, (c) one party who is common to all the contracts of the
joint inputs, (d) who has rights to renegotiate any input's contract independently of contracts
with other input owners, (e) who holds the residual claim, and (f) who has the right to sell his
central contractual residual status.”
20
Theory of the firm
The team production model as a first shot at the

corporate governance problem
Alchian/Demsetz model
• Problem: “incentive misalignment” (private marginal product < social marginal
product)
• Solution: Ownership of residual claim (owner’s private marginal product =
social marginal product)  owner “aligns incentives” of team members through
monitoring and penalizing
“Corporate governance as minimization of agency costs of equity”

builds on and extends the basic model
• Separation of ownership and control
• Incentive alignment other than by monitoring and penalizing
Keep for later: Should corporate governance also serve other stakeholders (than
shareholders) and the public interest? 21
Classes 1 & 2
Section 2: Foundations of principal-agent theory
22
Principal-agent theory
Agency as a general theory

of incentive problems (1)
• Alchian/Demsetz (1972) was a special case of misaligned incentives

• Incentive problems can arise if there are “external effects”: an individual’s
behavior has an effect not only on herself but also on others
• Principal-agent relation:
̶ The agent’s behavior has an effect on the interests of a principal
̶ Typically, we think of a contractual relationship under which agent is
supposed to conduct a business on behalf of the principal
̶ Examples: insurance agent-insurer; lawyer-client; asset manager-
investor; manager-shareholders; etc.
23
Agency as a general theory

of incentive problems (2)
• Usually in economics, if parties enter into a contract external effects can be
“internalized”: principal can pay the agent to take his interest into account,
thereby aligning the agent’s interest with his own
• Principal-agent problem arise due to asymmetric information: the agent
knows more than the principal (and a court)
̶ Hidden information, e.g., the agent knows more about her ability
̶ Hidden action, e.g., the agent knows more about how much effort she has
made (we will focus mostly on hidden action)
• Asymmetric information prevents full internalization
̶ To the extent the principal does not know the agent’s ability, he cannot
reward superior ability  hidden information leads to adverse selection
̶ To the extent the principal does not observe the agent’s effort, he cannot
reward high effort  hidden action leads to moral hazard
24
A hypothetical case
Ritchie owns € 10 million invested in partnerships and a stock portfolio. He wants

to hire Mary, a talented business student, to manage his wealth while he serves a
one-year prison sentence for tax evasion. Mary is willing to take the year off if she
can make a decent amount of money. She demands a higher salary if she has to
work harder.
We measure her effort in hours worked per day. Up to a certain point, the
investment returns on Ritchie’s assets rise with Mary’s effort. Beyond that,
additional effort does not add anything (e.g., working 13 or more hours per day).
Ritchie cannot observe how much Mary works.
25
A hypothetical case: full observability (1)
For the moment, we assume that Mary’s effort translates immediately and with
certainty into Ritchie’s wealth after the year. The following graph depicts Ritchie’s
final wealth (red line) depending on Mary’s effort and the corresponding minimum
salary Mary demands (her “reservation wage”, blue line).
14000
€ 1,000
12000
10000
8000
Note the large difference
6000
between the reservation
wage and the effect on the 4000
principal’s wealth
(presumably quite realistic 2000
for many agents) 0

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Hours
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
worked
Reserv.
0 7 14 22 30 39 48 58 69 82 98 119 153 198 268
wage (T€)
Final wealth
6000 7500 8600 9400 10000 10480 10860 11150 11360 11500 11580 11630 11650 11650 11610
(T€)
• In an ideal world, we want the agent to make the “first best” choice
• Mary should work 11 hours per day. Why is this the first best?
• Suppose Mary accepts any contract that makes her at least as well off as
without working for Ritchie. What does the optimal contract – from Ritchie’s
perspective – look like? Remember: neither Ritchie nor a court observe how
much Mary works; but Mary’s effort translates exactly in Ritchie’s final wealth
according to the table (a very unrealistic assumption!)

• Terminology: The contract between the principal and the agent is often referred
to as an “incentive scheme” for the agent
• A first-best incentive scheme has to satisfy two conditions
̶ Participation constraint: the agent must be induced to accept the
contract; she has to be at least as well off as without the contract
̶ Incentive compatibility constraint: the contract should induce the agent
to behave optimally
• In our hypothetical, it is easy to satisfy the two conditions:
̶ Incentive compatibility constraint: Ritchie wants Mary to work 11 hours; to
induce her to exercise effort, the contract rewards Mary only if she works
11 hours, which can be observed indirectly from Ritchie’s final wealth
̶ Participation constraint: Given that Mary will work 11 hours when she
accepts the contract, she has to be paid enough to at least compensate
her for the effort
From the principal’s point of view, the optimal incentive scheme also should keep28
the wage paid to the agent to the minimum
Introducing randomness
• In reality, Mary’s work hardly maps one-to-one to Ritchie’s final wealth;
outcomes often involve randomness
• Some very basic terminology of probability theory:
̶ A random variable (or stochastic variable) can take on a set of different
values (or realizations) with a given probability
E.g., roll of a die; Ritchie’s final wealth; the outcome of the next election
̶ The expected value of a random variable is the sum of its possible
values weighted by their probabilities
E.g., the expected value of the roll of a die is
1 1 1 1
1 + 2 + ⋯ + 6 = 1 + 2 + ⋯ + 6 = 3.5
6 6 6 6
̶ Depending on context, randomness is sometimes referred to as risk(1),
uncertainty(2) or noise
• Randomness can also relate to present or past events, e.g., “has my partner
bothered to fill the fridge or do I need to buy groveries?”
(1) “Risk” can also mean the degree of variability (as measured, e.g., by the variance/standard deviation)
(2) Many authors follow Knight (1921) and Keynes (1937) in reserving “uncertainty” for instances where actors
lack quantifiable probabilities for possible outcomes
A hypothetical case: noisy observability (1)

Now, let us assume somewhat more realistically prob. 0,8
Ritchie’s final wealth depends on Mary’s effort and 0,6
also on luck. To simplify, Ritchie’s final wealth will 0,4

be either € 14 million or € 6 million. Mary’s effort 0,2
determines the probability of the good outcome. 0
0 2 4 6 8 10 12 14
Hours
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
worked
Reserv.
0 7 14 22 30 39 48 58 69 82 98 119 153 198 268
wage (T€)
Prob. of
final wealth .0000 .1875 .3250 .4250 .5000 .5600 .6075 .6438 .6700 .6875 .6975 .7038 .7063 .7063 .7013
€14 mn.
Prob. of
final wealth 1.000 .8125 .6750 .5750 .5000 .4400 .3925 .3562 .3300 .3125 .3025 .2962 .2937 .2937 .2987
€6 mn.
Expected
final wealth 6000 7500 8600 9400 10000 10480 10860 11150 11360 11500 11580 11630 11650 11650 11610
(T€)
• Assume that Ritchie and Mary are both “risk neutral” (explanation to follow)
• The first best behavior for Mary is still to work 11 hours because this
maximizes the total expected value for Ritchie and Mary jointly
• In the original case, although Ritchie could not observe Mary’s effort, he was
able to infer her effort exactly from his final wealth
• Now, Ritchie can still observe his final wealth but this is only a probabilistic
indication (“noisy signal”) of Mary’s effort: if Ritchie obtains the good outcome,
it is only more likely that Mary has made a higher effort
• Surprisingly, Ritchie can still offer an optimal contract for himself
̶ Ritchie’s optimal contract induces first-best effort and does not give Mary
more than her reservation wage
̶ What does this contract look like? (This is one of those think-outside-the-
box riddles; hint: we have not said anything about how wealthy Mary is)
31
• Trivial moral: you can eliminate principal-agent problems by making the agent
the principal (owner)
• Less trivial: agency costs arise if and because the agent has too little wealth to
buy the principal’s business
• Assume Mary has zero wealth
• Just to repeat: why is it not optimal just to pay Mary her reservation wage for
first best effort (that is, €119,000)?
• What other contract should Ritchie resonably offer to Mary?
32
Hours
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
worked
Reserv.
0 7 14 22 30 39 48 58 69 82 98 119 153 198 268
wage (T€)
Prob. of final
wealth .0000 .1875 .3250 .4250 .5000 .5600 .6075 .6438 .6700 .6875 .6975 .7038 .7063 .7063 .7013
€14 mn.
Exp. final
6000 7500 8600 9400 10000 10480 10860 11150 11360 11500 11580 11630 11650 11650 11610
wealth (T€)
5% share(1):
total exp. 0 75 130 170 200 224 243 257.5 268 275 279 281.5 282.5 282.5 280.5
reward (T€)
10% share(1):
total exp. 0 150 260 340 400 448 486 515 536 550 558 563 565 565 561
reward (T€)
Even the 10% sharing contract fails to

induce first-best behavior! First best
(1) Share of final wealth in excess of € 6 mn. (that is, share of € 8 mn. or zero)
1200 12000
10 hrs.
1000 X 11000
X
X
X X
800 9 hrs. 10000
X
600 9000
9 hrs.
20% share X
15% share 400 8000
10% share 7 hrs.

5% share 200 X 7000
0 6000
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Total expected reward for Mary Expected final wealth for Ritchie
minus reservation wage minus reward paid to Mary 34
A hypothetical case: noisy observability –

conclusions
With less than perfect observability of the agent’s effort (asymmetric information)
• If the agent has enough wealth (and risk-bearing is costless), the principal
should “sell” his business to the agent  gets rid of agency, full internalization
• With limited wealth of the agent, there will typically be a tradeoff between
incentivizing the agent and minimizing her compensation
̶ The principal has to pay the agent more than her reservation wage
 an “efficiency wage” (that seeks to induce efficient behavior) or more
generally an “information rent” (a benefit the agent derives from her
informational advantage)
̶ Because the principal wants to limit the information rent, the agent’s
incentives deviate from the first best  the optimal contract (for the
principal) induces only the “second best” behavior
Now we see one reason why managers earn so much: with 10% sharing, Mary gets
an expected pay of € 550,000 for 9 hours work at € 82,000 personal cost! 35
Introducing risk-bearing costs
“Risk”
In economics and finance, “risk” does not refer to a “probability of loss” as in everyday
parlance. Instead, it means the degree of uncertainty of a variable, that is, its variability.(1)
• To illustrate:
̶ Investment A yields €100 for sure
̶ Investment B yields €50 with probability .5 and €150 with probability .5
̶ Both investments have the same expected value of €100 but investment
B is (much) more risky
• Most people are not risk neutral but risk averse: They strongly prefer
investment A over investment B
• To induce them to buy investment B, it must cheaper than investment A
 people have to be compensated to bear risk  risk-bearing costs
(1) For a better and more precise mathematical definition, see Rothschild/Stiglitz, Increasing Risk:
I. A Definition, J. Econ. Th. 2 (1970), 225 36
Risk-bearing costs make it more expensive for

the principal to induce optimal behavior
• Assume that the principal is less risk-averse than the agent (why is this often a
reasonable assumption?)
• If the principal cannot precisely observe effort, the contract has to use a noisy
indicator to provide incentives (as in the contract between Ritchie & Mary)
•  The agent’s pay depends not only on her effort but also on luck (under the
contract with Ritchie, Mary gets either “a lot” or zero; this is risk!)
• This creates an additional tradeoff (even if the agent had sufficient wealth)
̶ The principal wants the agent’s pay to depend strongly on the indicator
̶ But then he has to pay a higher expected wage to compensate the agent
for the risk
• This is another reason why the optimal contract may not induce first-best
behavior
37
The effect of risk-bearing costs:

the agent’s effort choice
Suppose Mary has just inherited € 5,510,999. Ritchie asks her to pay this sum to
him in exchange for all of Ritchie’s final wealth in excess of € 6 million. Ritchie
makes the following argument: If Mary works 11 hours per day, Ritchie’s expected
final wealth will be € 11,630,000, of which Mary gets €5,630,000 in expected
value (.70375(1)  € 8 million). Mary’s reservation wage for 11 hours work is
€119,000. Overall, the claim to Ritchie’s final wealth beyond € 6 million should be
worth €5,511,000 to her. Isn’t this a good deal?
• Would you pay € 5 million (if you had them) for a chance of 50% to win
€ 10 million and zero otherwise?
• Even if the agent has enough wealth, her greater risk aversion prevents her
from taking over all of the principal’s risk (although this could perfectly align her
incentives)
The agent’s greater risk aversion is an additional reason why the agent does not
simply buy the principal’s business  this will be an important insight later on 38
(1) Note that probabilities in the tables above were rounded to four decimals

the agent’s risk choice (1)
Let us go back to the case where Mary has no wealth of her own. She is risk
averse, Ritchie is risk neutral. Now, we add a second choice that Mary has to
make: Before choosing effort, she can decide to invest Ritchie’s assets either
“risky” or “safe”. The risky option is the one described in the tables above. The
safe choice yields € 10 million with certainty if Mary works 4 hours per day; if she
works less, the bad outcome with € 6 millions obtains.
Suppose that Ritchie and Mary agree on the 10%-share contract.
39

the agent’s risk choice (2)
• With the risky strategy, Mary works 9 hours per day(1), which causes her
personal costs of €82,000; for this effort, she gains a 68.75% chance of
winning €800,000 and zero otherwise
Net expected benefit: €550,000 – €82,000 = €468,000
• With the safe strategy, she will work 4 hours per day at a personal cost of
€30,000; in exchange, she gets €400,000 for sure
Net (expected) benefit: €370,000
• Mary may well prefer safe €370,000 to a 68.75% chance of winning €718,000
or else losing €82,000
• To Ritchie, the safe choice would cause a large loss: €1,350,000(2)
Agency problems arise not only from too little effort but also from distortions in the
agent’s decisions on behalf of the principal. Risk choices are a prime example.
(1) In fact, this is not quite correct: Her risk aversion will likely make her work either more or less under a 10%
contract; in consequence, the 10% contract may no longer be optimal.
(2) The risky strategy gives him an expected value of €11,500,000 – €550,000 = €10,950,000; if Mary plays it
safe, his expected net wealth is €10,000,000 – €400,000 = €9,600,000.
Main lessons about agency costs:

risk-bearing costs and information rents (1)
• Agency costs arise if the agent’s incentives are not fully aligned with the
principal’s
• One way to fully align the agent’s incentives is for the agent to acquire the
principal’s business = full internalization
• There can be other, less extreme solutions; sometimes they even achieve the
first best
• A necessary condition for agency costs to arise is that full internalization does
not take place because of
̶ risk-bearing costs
̶ limited wealth of the agent (or, equivalently, “limited liability”)
41

Risk-bearing costs
• To align incentives, the agent must be exposed to the principal’s risk

• If the agent is more risk averse than the principal, exposing him to risk is costly
• Optimal contract lets agent bear less than full risk  only second best effort
 social loss
• Risk borne by agent can distort her risk-taking decisions on behalf of the
principal  social loss
• In an ideal world, the principal would bear all the risk
 social loss; also, principal has to compensate the agent
42

Limited wealth/liability of the agent

• To align incentives, the principal must share his future benefits with the agent
• If the agent has only limited wealth, she cannot pay for receiving a share in the
principal’s future benefits  “information rent” at the expense of the principal
• To limit the information rent, the principal agrees only to a lower share for the
agent  only second best effort  social loss
• The information rent as such is not a social loss: the agent gains what the
principal loses; but: principal less willing to use agent  fewer valuable
delegation  social loss
43
Classes 1 & 2
Section 3: Agency costs of equity—the

separation of ownership and control
44
Agency costs of equity
Appetizer: a famous quote
Adam Smith (1723–1790), Wealth of Nations, 3d ed. 1784, vol. III, pp. 123–4:
“But the greater part of those proprietors seldom pretend to understand any thing of the
business of the company; and when the spirit of faction happens not to prevail among them,
give themselves no trouble about it, but receive contentedly such half yearly or yearly dividend,
as the directors think proper to make to them. This total exemption from trouble and from risk,
beyond a limited sum, encourages many people to become adventurers in joint stock
companies, who would, upon no account, hazard their fortunes in any private copartnery. The
directors of such companies, however, being the managers rather of other people’s money
than of their own, it cannot well be expected, that they should watch over it with the same
anxious vigilance with which the partners in a private copartnery frequently watch over their
own. Like the stewards of a rich man, they are apt to consider attention to small matters as not
for their master’s honour, and very easily give themselves a dispensation from having it.
Negligence and profusion, therefore, must always prevail, more or less, in the management of
the affairs of such a company.”
Adam Smith predicted the “joint stock company” to remain a marginal and
inefficient institution, given its severe incentive problems(1)
(1) Fleckner, Adam Smith on the Joint Stock Company, Working Paper of the Max Planck Institute for 45
Tax Law and Public Finance No. 2016-1
The “separation of ownership and control”
• Remember Alchian/Demsetz (1972): the capitalist owner as a single person

holding the residual claim and serving as central contract party
• Single-owner firms do exist but most larger firms have multiple owners
• “Berle-Means corporation” as classical object of corporate governance
research
̶ Berle/Means, The Private Corporation and Private Property, 1932
̶ “Separation of ownership and control”: shareholders (residual claimants)
vs. managers (controllers)
• Not confined to large public corporation: even in small partnerships and
corporations ownership and control are to some degree separated;
partners/shareholders expose themselves to control by other
partners/shareholders or professional managers
The separation of ownership and control causes agency problems. Why do owners
incur these costs? This is the first key question raised in Jensen/Meckling (1976). 46
Why do owners knowingly incur agency costs?
• The natural solution to agency problems is to have the agent acquire the
principal’s business
• Jensen/Meckling (1976) ask essentially the same question: why do firm
owners (entrepreneurs, insiders) sell a share in the firm to outsiders?
• Division of labor between “decision functions”(1) (managers, insiders) and
“residual risk bearing”(1) (outside shareholders)
• The decision of the “insiders” to sell shares in the firm to “outsiders” is the
result of a trade-off between
̶ risk-bearing costs and opportunity costs from lack of funding, and
̶ the “agency costs of outside equity” (Jensen/Meckling 1976)
An implicit assumption is that “insiders” are better at managing the firm. But why
are outsiders better at bearing risk and providing funding? 47
(1) Fama/Jensen, Agency Problems and Residual Claims (1983)
Advantages of outsiders at funding and risk-

bearing (1)
Why can outsiders be better at funding the firm?
• Trivially, only by luck do managerial ability and entrepreneurial spirit coincide

with sufficient wealth
• Also trivially, there are many more outsiders than able managers and
entrepreneurs; “many” tend to have more money than “few”
• An additional, more sophisticated explanation: secondary markets as liquidity
providers
̶ Investors can liquidate their shareholding by selling to other investors
̶ The firm does not have to liquidate its real investments if the shareholders
need cash
̶  “Fisher separation”(1) between individual investment/consumption
preferences over time and the firm’s investment policy
(1) Named after the US economist Irving Fisher (see Fisher, The Theory of Interest, 1930, pp. 221 ff.) 48

bearing (2)
Why can outsiders be better at bearing risk?
• If outsiders were richer (which we don’t know), they would be less risk averse
• The more sophisticated story: if there are many outsiders, they can diversify
̶ Diversification as a “free lunch” in finance

(portfolio theory, Harry Markowitz)
̶ Example: (1) one coin toss, heads you win
€1,000, tails you get nothing, or (2) 1,000 coin
tosses, heads you win €1, tails you get nothing
Expected value for (1) and (2) is €500. How much would you pay for
lottery (1) or (2)? What is the probability to win €450 or less in (2)?
̶ Bottom line: outsiders can slice their investments in small pieces to
reduce their risk  diversification is the great virtue of securities markets
(including prepackaged portfolios such as investment funds) 49

bearing (3)
Why can outsiders be better at bearing risk? (cont’d)
• An analogue to “Fisher separation” also applies to corporate risk choices:
̶ If shareholders prefer less (or more) risk, they can sell their shares
̶ Separation of individual risk preferences and the firm’s investment
̶ E.g., when shareholders approach retirement and become more risk
averse, the firm can still take high risk
50
Agency costs of equity: managers as insiders (1)
• Agency costs can result literally from lack of effort/laziness; yet in reality,
managers seem to work a lot
• “Entrenchment”: managers can build power within the firm to protect
themselves against replacement
̶ Costly if managers turn out less capable, pursue an unsuccessful
strategy, or fail in other ways
̶ Example: resignation of Jürgen E.
Schrempp as CEO of Daimler in July
2005 (ECJ C-19/11 (Geltl/Daimler))
̶ Somewhat nasty empirical evidence:
stock price reactions to CEO sudden
deaths(1)
(1) Salas, Entrenchment, governance, and the stock price reaction to sudden executive deaths,
J. Banking & Fin. 34 (2010), 656 (stock price increases strongly upon death of long-time 51
executives when risk-adjusted stock price returns have been negative in previous three years)
• “Empire building”, “managerial aggrandizement”

̶ Executive compensation tends to rise with firm size; celebrity status
̶ Example: Daimler-Chrysler merger 1998; Mr. Schrempp elected
“manager of the year 1998”
• “Pet projects” that managers love but
are hugely unprofitable
• Possibly: currying favor with employees
by paying excessive wages or tolerating
organizational slack
• Possibly: corporate giving
• The latter two examples could also be
good corporate policy
VW Transparent Factory (“Gläserne
Manufaktur”) in Dresden; (photo: Henn
Architekten)
52

• Excessive compensation (compensation can be an agency
problem but can also be part of the solution)(1)
• “Perk consumption” (perk = perquisites, i.e. employee
fringe benefits)
̶ Dennis Kozlowski, CEO of Tyco International (“Tyco
Roman Orgy”: birthday party for his wife at $2 mn.,
declared a shareholder meeting)
̶ The corporate jet fleets of US public firms are 40%
larger than those of similar firms owned by private
equity investors(2)
• Conflicts of interests, in particular self-dealing
• Taking advantage of corporate opportunities
• Outright misappropriation
(1) Bebchuk/Fried, Executive Compensation as an Agency Problem, What’s David got to
J. Econ. Persp. 71 (2003), 17 do with Tyco?
53
(2) Edgerton, Agency Problems in Private Firms: Evidence from Corporate Jets in
Leveraged Buyouts, J. Fin. 67 (2012), 2187
Agency costs of equity:

controlling shareholders as insiders (1)
• Corporate governance debate often focuses on managers as insiders/agents
• In the Jensen/Meckling (1976) story, controlling shareholders are the natural
insiders: founders of successful firms “go public” to raise capital and diversify
their wealth (example: dual-class shares at Alphabet/Google)
• Other corporations are another type of controlling
shareholders (“corporate groups”)
• Agency problems:
̶ Lack of effort, empire building, pet projects etc.
presumably less of a problem (why?)
̶ Conflicts of interest can be even more
problematic than with managers (why?)
̶ Example: until 2006, VW held only 15% of MAN
AG; guess which cars MAN bought for its
executives and lower-tier managers? Who was
54
chairperson of MAN’s supervisory board?
Agency costs of equity:

controlling shareholders as insiders (2)
100
• Stylized facts for “public” 90
(listed) firms 80
70
̶ Many public firms have 60
controlling/influential 50
shareholders 40
30
̶ Most controlling
20
shareholders are families
10
̶ Internationally, 0
continental Europe has
more controlling
shareholders than UK/US
Percentage of listed firms in 1996 with at least one
• The data is of 1996 and may shareholder holding more than 20%; blue bars indicate any
not be very reliable 20%-shareholders, light blue bars family shareholders
(Sources: Gadhoum/Lang/Young, Who Controls US, Eur.
Fin. Mgmt. 11 (2005), 339; Faccio/Lang, The ultimate
ownership of Western European corporations, J. Fin.
Econ. 65 (2002), 365)
A goal for corporate governance: minimizing the

agency costs of equity
• From an agency cost perspective, a first aim of corporate governance is to
minimize the agency costs of equity from
̶ Incentive misalignment
̶ Risk bearing costs, information rents
̶ Monitoring and bonding costs, i.e. costs for overcoming agency
problems (we have not mentioned them so far)
• Jensen/Meckling (1976, p. 308): agency costs consist of (1) monitoring
expenditures by principal, (2) bonding expenditures by agent, (3) residual loss
• Corporate governance can be seen as a comprehensive “incentive scheme”
for insiders (agent)
• Important insight: ex ante, when insiders sell shares to outsiders, both sides
have a common interest in minimizing agency costs (Jensen/Meckling 1976,
p. 328)  why?
In the following, we will consider the elements of corporate governance (as incentive
56
scheme) that can help to reduce the agency costs of equity
Agency costs of equity and the law:

managers’ fiduciary duties (1)
If agency costs are bad, why does the law not simply
prohibit mismanaging the firm? Managers could be held
liable for damages or criminal sanctions
§ 93 AktG(1)
(1)1In conducting business, the members of the management board shall employ the care of a
diligent and conscientious manager. 2They shall not be deemed to have violated the
aforementioned duty if, at the time of taking the entrepreneurial decision, they had good
reason to assume that they were acting on the basis of adequate information for the benefit of
the company. […]
(2) 1Members of the management board who violate their duties shall be jointly and severally
liable to the company for any resulting damage. 2They shall bear the burden of proof in the
event of a dispute as to whether or not they have employed the care of a diligent and
conscientious manager. […]
§ 266 StGB (Criminal Code)
(1) Whoever […] violates the duty to safeguard the property interests of another incumbent
upon him by reason of statute, commission of a public authority, legal transaction or fiduciary
relationship, and thereby causes detriment to the person, whose property interests he was
responsible for, shall be punished with imprisonment for not more than five years or a fine.
(1) Translation based on Norton Rose LLC

• German rules on director liability are particularly strict (burden of proof!)
• Traditionally, enforcement has been weak (cf. §§ 142–147 AktG; BGH 21 April
1997 – II ZR 175/95, BGHZ 135, 244 (ARAG/Garmenbeck))
• Think about director liability as part of an incentive scheme:
 Director is penalized …
 … if the firm suffers a loss (harm) and a court finds a breach of the
fiduciary duty of care
• Remember why agency costs arise in the first place: effort and optimal
decision-making are not (perfectly) observable
• This suggests that courts have difficulties to determine a breach of the
fiduciary duty of care (“mismanagement”)
• If courts make many errors in adjudicating directors—how does this affect their
incentives?
58

• Holding directors liable for ill-conceived business decisions exposes them to a
lot of “downside” risk, while they have only some share in the “upside”
 directors will tend to avoid risky investments
•  Business judgment rule, § 93(1) sent. 2 AktG: no liability if
 “entrepreneurial decision”,
 “good reason to assume that […] acting on the basis of adequate
information”, and
 “good reason to assume that […] acting […] to the benefit of the
corporation”
• The German business judgment rule and its interpretation is still very strict
compared to the US (burden of proof; “adequate information” requirement)
• If a director violates a legal duty (other than the general duty of care), this is
no longer an “entrepreneurial decision”
 special compliance and compliance oversight duties
59

• Business judgment rule prevents court-imposed liability from interfering with
overall incentive scheme to induce effort and optimal decision-making
• But: incentive scheme doomed to fail if managers stand to benefit at the
expense of the firm (“can’t deter stealing by promising 5% of final net worth”)
Directors’ fiduciary duties
Duty of care Duty of loyalty

Conflicts of interest  disclosure,
ratification, abstention, e.g.:
Business judgment rule
• Non-compete (§ 88 AktG)
• Self-dealing (cf. § 181 BGB,
§ 112 AktG)
• Corporate opportunities 60
Ways of minimizing the agency costs of equity:

“internal governance” (1)
Shareholders as monitors
• Even if shareholders cannot manage the corporation themselves, they could at
least control managers’ decisions
“Decision management” (“initiation”, “implementation”) vs.
“decision control” (“ratification”, “monitoring”)(1)
• Impediment: outside shareholders as small financiers do not specialize in
assessing business decisions(1)
• Impediment: the shareholders’ collective action problem
̶ Paradigmatic outsider is well diversified and holds only (very) small share
in the firm
Suppose better monitoring increases firm value by 20%; how much
effort is worthwhile if you hold a portfolio of € 1 mn. equally diversified
in shares of 50 firms?
61
(1) Fama/Jensen, Separation of Ownership and Control (1983)

Shareholders as monitors, cont’d
• The outside shareholders’ collective action problem, cont’d
̶ Shareholders need to coordinate, which is costly
̶ Individually, shareholders are better off free riding on others’ effort
̶ Individually, shareholders may find it more attractive to look for better
managed firms and shift their investment  “Wall Street Walk”
• The “rational apathy” and “rational ignorance” of outside shareholders is a
perennial challenge of corporate governance in public firms
• Astonishing discrepancy between the amount of capital shareholders invest
collectively and the lack of attention they devote to the firm
Quote attributed to Carl Fürstenberg (1850–1933)

“Shareholders are stupid and impertinent—stupid because they entrust their money to others
without any effective control over what they are doing with it and impertinent because they ask
for a dividend as a reward for their stupidity”

Shareholders as monitors, cont’d
• Apathy and ignorance are only (individually) rational for investors with small
shares
• Blockholders are less diversified and cannot liquidate easily
•  controlling/influential shareholders can significantly reduce the agency costs
of equity in relation to managers
• At the same time, controlling shareholders as insiders cause agency costs of
equity, which are even harder to control for outside shareholders
63

Delegated monitoring: board of directors
• Germany has a two-tier structure with a “management board” (Vorstand)
overseen by a “supervisory board” (Aufsichtsrat)
• Comparatively, a unitary structure with a single “board of directors”
predominates; but distinction between “executive directors” and “corporate
officers” (such as CEO, CFO, etc.) and “outside/independent directors”
• The composition and working of the board is perhaps the single most
discussed topic in corporate governance
• Arguably the greatest power of the board is to be able to fire managers (or to
not extend their term)
̶ Being fired means that managers lose future income from the firm
̶ Being fired likely tarnishes managers’ reputation in the managerial labor
market(1), which determines overall loss
̶ Being fired is not a pleasant experience 64
(1) Fama (1980)

Delegated monitoring: board of directors, cont’d
• Sed quis custodiet ipsos custodes? Why should we expect the board to
perform any better than managers themselves (without monitoring)?(1)
̶ Monitoring and
disciplining requires less
effort than managing
(“decision management”
vs. “decision control”)(1)
̶ Board acts only as
referee  little incentive
to benefit managers
̶ Reputational concerns of
directors
Pollice Verso (1872) by Jean-Léon Gérôme
Of course, incentives of outside directors are far from perfect  ongoing debates
(1) Fama/Jensen, Separation of Ownership and Control (1983), pp. 310 et seq.

Explicit compensation incentives
• “Excessive compensation” can be an agency cost
• But performance-
based compensation
can also help to align
managers’ incentives
• The graph compares
“average pay” for a
CEO of a firm with
sales of $ 1 bn. in
2006(1)
• Average CEO pay in
Germany in sample
$3.6 mn.
(1) Fernandes/Ferreira/Matos/Murphy, Are U.S. CEOs Paid More? New International Evidence, 66
Rev. Fin. Stud. 26 (2013), 323

“external governance” (1)
Stock market
• How can stock market prices discipline managers?
̶ Insiders may need the stock market in the future to raise new capital
̶ (Institutional) shareholders focus on the stock market price to evaluate
management  board also looks at stock market to evaluate managers
̶ Stock-based compensation
̶ High stock price as the best defense against hostile takeovers in the
“market for corporate control” (more about this later)
̶ Important force in corporate
governance: “activist
investors”
67

Stock market, cont’d
• But have we not concluded that outside shareholders are not good at
monitoring managers? After all, the stock market consists of outside investors
• Key difference: no collective action problem in price formation
̶ In exercising control rights, individual shareholders promote the collective
welfare of all shareholders in the corporation
̶ In making investment decisions, they seek a profit for themselves
̶ Capital market “arbitrage”: exploiting mispricings (buying low and selling
high) tends to correct market prices
̶  Strong incentive to become informed and value securities correctly
̶ Specialized arbitrageurs (“smart money”) can correct mispricings even if
most investors remain uninformed (“noise traders”)
68

Stock market, cont’d
• The “shareholder value” movement makes two different claims:
(1) Corporations should be managed only for the benefit of shareholders
(shareholder primacy)
(2) Shareholders are exclusively interested in maximizing the stock price
• We know already the theoretical underpinnings of (2):
̶ ECMH: the present price is the best estimate for future market returns
̶ (Fisher) separation between individual time/risk preferences and
corporate investment  “unanimity principle”: all shareholders can agree
on maximizing the stock price as their common goal (why?)
69
Classes 1 & 2
Section 4: Shareholders, stakeholders

and the public interest
70
Shareholders, stakeholders and the public interest
Shareholder vs. stakeholder model
• The “agency costs of equity” focus on the interests of shareholders

• How did we discuss “shareholder value” in the context of the agency costs of
equity?
• Another aspect of “shareholder value”: the objective of managers and of
corporate governance arrangements should exclusively consist of promoting
shareholder interests = shareholder primacy
• The debate about the shareholder or stakeholder model is a great,
fundamental question in corporate governance scholarship
The case for shareholder primacy (1)
• Once again Alchian/Demsetz (1972):

̶ The firm owner as nexus of contract has the “residual control right”
̶ Making the firm owner the residual claimant incentivizes her to monitor
and discipline team members (more generally: to allocate inputs to the
most productive use)
̶ Leaving residual control and the residual claim to the owner is good for
team members and society: competition in input and output markets
drives the expected value of the owners’ residual claim down to the costs
of monitoring/disciplining  “higher wages, lower product prices”
• Does the separation of ownership and control undermine the argument?
̶ (Outside) shareholders monitor and control only little, if at all
̶ But outside shareholders delegate control to insiders as “their” agents and
intervene in extreme cases (takeovers, shareholder activists)
72
• Shareholders must be paid not only for monitoring/control but also for providing
capital and for bearing risk
̶ Residual claim (equity) is the riskiest stake in the firm
̶ More importantly, the “residual” claim is not specified at all: whoever
controls the firm can reduce the residual claim to zero (e.g., by paying
above-market wages)
̶ Individual shareholders typically cannot withdraw their investment
• Shareholders are most vulnerable to ex post expropriation of their quasi-rents
 shareholder primacy as a way to incentivize equity investment
73
• To illustrate, suppose the risk-adjusted market return for shares in a particular

firm is 10%; the firm needs €100 in equity investment; after a year, the firm will
make a profit with probability .5, resulting in an equity value of €120; otherwise,
there will be no profit and equity will be worth €100
After the firm has made a profit, labor representatives might argue: “Why
should this highly successful year only benefit shareholders? It is only fair to
award employees an extra appreciation of, say, €6. This leaves shareholders
€14 in profits, which is far more than their expected market return.”
Where is the flaw in this reasoning?
If the firm is expected to redistribute profits away from shareholders to other

stakeholders, it will be constrained in raising equity; that is, it will only be able to
finance investments with a particularly high return
74
The case for the stakeholder model (1)
• Alchian/Demsetz (1972) are right that other stakeholders have more “fixed”
claims than shareholders: creditors are entitled to principal and interest,
employees to wages, etc.
• But there are agency costs not just of equity but also of debt, because fixed
claims may not be paid in full:
̶ Even extensive “covenants” cannot fully specify the permissible risk
̶ Covenants mostly serve to trigger renegotiation of the loan  evidently,
debt contracts are quite “incomplete” (not fully specified or “fixed”)
̶  Covenants are control rights
̶  Creditors can benefit if corporate governance does not exclusively
cater to shareholders; for instance, firms seem to be less risky if
managers hold more “inside debt” (e.g., from pension benefits)(1)
(1) See, e.g., Cassell/Huang/Sanchez/Stuart, Seeking safety: The relation between CEO inside debt
holdings and the riskiness of firm investment and financial policies, J. Fin. Econ. 103 (2012), 588 75
The case for the stakeholder model (2)
• Even more important may be labor contracts:

̶ Specific investments by employees: investments in firm-specific human
capital (learning firm-specific skills, technologies, organizational routines,
co-workers, sense of loyalty, etc.); developing a reputation with the
employer; location choice close to employer, etc.
Evidence: workers who lose their employment in mass layoffs (i.e., for
firm-related, not individual reasons) suffer sustained losses in average
income and even a higher mortality(1)
̶ Labor contracts are very incomplete with regard to future wages, career
opportunities, and employment safety
̶ Labor law provides some protection (e.g., against unfair dismissal); we
will talk about codetermination soon
(1) Eliason/Storrie, Lasting or Latent Scars? Swedish Evidence on the Long-Term Effects of Job
Displacement, J. Labor Econ. 24 (2006), 831 (long-run average annual income losses $700–1,000
and 5–13 percentage points greater unemployment risk in Sweden); Sullivan/von Wachter, Job 76
Displacement and Mortality: An Analysis Using Administrative Data, Q. J. Econ. 124 (2009), 1265
Intermediate positions
• The stakeholder (or “total firm value”) view is right only in theory: it is true that
other stakeholders are vulnerable; but corporate governance needs a clearly
defined and measurable objective that only shareholder primacy provides
 “No one can serve two masters”
• “Enlightened shareholder value”: maximizing profits at the expense of
stakeholders’ unprotected quasi-rents hurts the firm’s reputation; in the long
run, shareholders benefit more from honoring the firm’s relational obligations
How do the two positions relate to the idea of shareholder value = stock price?
77
Does the shareholder–stakeholder debate matter

for the law?
• It is often claimed that corporate law has to take a stance on shareholder

primacy in order to define managers’ fiduciary duties
̶ Evidently, managers have to comply with specific duties on behalf of
stakeholders (e.g., legal capital rules, labor safety rules)
̶ Beyond such specific rules, the shareholder/stakeholder debate rarely
makes a difference because the business judgment rule largely insulates
managers from liability (possible exception: directors’ duties in the vicinity
of bankruptcy)
• Would management compensation have to differ fundamentally if the law
adopted a stakeholder view?
78
Does the structure of the German stock

corporation reflect the stakeholder view? (1)
• Shareholder meeting has only competences stated explicitly in the statute, see
§§ 119(1), 179a, 293, 320 AktG, 13, 65 UmwG – often fundamental changes of
the corporate structure
• Management board
̶ Exclusively in charge of day-to-day management, § 76(1) AktG; must
consult supervisory board on certain important matters, § 111(4) AktG;
can consult shareholder meeting to exclude liability, §§ 119(2), 93(4) AktG
̶ Supervisory board elects managing directors for maximum term of 5
years; it can remove managing directors but only for cause; shareholder
meeting’s vote of no confidence constitutes cause, § 84(3) AktG
• Shareholder bench of supervisory board elected by shareholder meeting for
maximum term of 5 years, § 102 AktG; can be removed by 3/4 majority in
shareholder meeting, § 103(1) AktG
79

Shareholder meeting
Elects, but
cannot instruct
Supervisory board Employees

Elect
Elects, but
cannot instruct
Board-level codetermination
Management board (unternehmerische Mitbe-
stimmung)
80

• Germany has the most robust board-level codetermination law among the
world’s largest economies
̶ One third of supervisory board directors to be elected by employees if
corporation (including LLC [GmbH]) has > 500 employees (One-Third-
Codetermination Act, DrittelbG)
̶ “Equal codetermination” (paritätische Mitbestimmung): half of supervisory
board directors elected by employees if > 2,000 employees
(Codetermination Act of 1976, MitbestG); but shareholder bench can elect
the chairperson who has casting vote, §§ 27, 29 MitbestG
• How does equal codetermination affect residual control over the firm?
• How will employee representatives likely use their power?
• Would you expect the shares of firms with codetermination to have a larger or
smaller market valuation (relative to the firm’s assets)?(1)
(1) Fauver/Fuerst, Does good corporate governance include employee representation? Evidence from
German corporate boards, J. Fin. Econ. 82 (2006), 673; Kim/Maug/Schneider, Labor Representation in
Governance as an Insurance Mechanism, Rev. Fin. 22 (2018), 1251
Classes 1 & 2
Section 5: Efficient capital markets
82
Efficient Capital Market Hypothesis (1)
- …postulates that market prices reflect available information related to the firm/issuer
whose security is traded
- Efficient markets are important for information, but also for disciplining firms or their
management
- …by (the threat of) takeovers and their consequences
- …by active investors
83
- Three levels of market efficiency, Fama (1970):

(1) Strong form of information efficiency: asset price reflects all available private
and public information
● consequence: insider trading would not pay off
(2) Semi-strong form of information efficiency: asset price reflects all publicly
available information (financial reports, ad hoc info, macroeconomic data)
● consequence: Trading based on financial reporting data does not pay off
● but who will do it then?
(3) Weak form of information efficiency: historical information (prices, earnings data
etc.) can‘t be used to predict future direction of asset price
● consequence: trend analysis does not pay off
● randon walk theory: future securities‘ prices are random
84

- How to prove information efficiency: abnormal returns when stock splits are
announced (Fama, Fisher, Jensen, Roll, International Economic Review 1969, 1-21)
- Stock splits: make shares more affordable, increase demand and liquidity
85

Three phases of efficient market hypothesis
 Supporting evidence for semi-strong form in 1960s
 Mixed evidence in late 1970s and through 1980s
 E.g. Ball (1978), Watts (1978): abnormal returns possible after (quarterly)
earnings announcements
 Charest (1978): abnormal post-announcement returns in the months after
announcements on dividend changes
 Challenging evidence in 1990s by behavioral finance researchers

 This research will elaborated in more detail on the next slides
86

-Empirical evidence does not seem (fully) in line with ECMH (Fama, Journal of
Financial Economics, 1998, 283-306):
-Evidence, that asset prices react too strongly or too slowly to new information (price
trends with over- and underreaction)
 Example overreaction: for longer periods relatively poor returns after IPOs, long-
term reversal of share price trends („past winners tend to be future losers“),
 Example underreaction: slow price adjustment even after announcements of
stock splits, dividend cuts or changes in earnings or dividends
Eugene Fama
(Nobel Prize 2013)
87

Reasons, why observable asset prices may deviate from fundamental values
even in the presence of information efficiency:
Noise trading models
Behavioral finance models
88
Andrei Shleifer Robert Shiller (Nobel Prize 2013)

Efficient market hypothesis relies on three basic assumptions (Limits to
arbitrage, Shleifer, 2000):
(a) Investors are rational

(b) To the extent they are not rational, their behavior is random and therefore cancels
out in the aggregate without affecting prices
(c) To the extent that investors are systematically irrational, there are rational
arbitrageurs who eliminate their influence of price
89

Three basic assumptions: Are investors rational?
Rationality implies perfect information processing

Example 1: There is a rare cancer, 0.01% of population has it. Test is positive,
reliability is 90%.
Question 1: What is the probability of you having cancer?
Example 2a (Tversky & Kahneman, 1981):

Please consider the following situation. There is a new Asian disease coming which
will cause 600 people to die, if they do not receive medical treatment. There are two
different programmes to fight the disease. Program A will save 200 persons.
Program B will save all 600 persons with probability 1/3 and nobody with probability
2/3.
Question 2: How is your decision?
90

Example 2b (Tversky & Kahneman, 1981):

There are two different programmes to fight the disease. With, program A 400
persons are going to die, with program B nobody is going to die with probability 1/3,
and all will die with probability 2/3.
Question 3: How is your decision?
91

Don‘t worry, you are not the only one who did not answer rationally.
Rather, it‘s systematic.
Want to hear more stories? Daniel, Hirshleifer, Subramanyam (Journal of Finance,

1998,1839-1885) assume there are uninformed and informed investors.
The informed investors are „overconfident“, i.e., they overestimate the precision of
their private information and undervalue publicly available information (biased self-
attribution).
Because of overweighting private information, stock price trends evolve for some
time („momentum“), which reverse in the long term, when publicly available
information prevails.
92

Another story: Barberis, Shleifer, Vishny (Journal of Financial Economics, 1998, 307-343)
get a similar „momentum“ result based on the assumptions that :
- Investors overweigh information from the recent past (representativeness bias)
and
- adjust their asset pricing model to slowly (conservatism).
- More illustrative examples for representativeness bias:
- „Bad feeling“ when entering an aircraft of an airline which recently crashed
- Significant stock price declines after scandals (e.g. Volkswagen 2015)
93

Moreover, many investors base their buy and sell decisions not even (only) on
information, but also on
 e.g., emotions / opinions / fashions / technical chart analysis, which all are
unrelated to fundamental information (noise trading)
 as a consequence, investment strategies might be correlated among
investors (herd behaviour), which influences asset prices
 Does arbitrage help?
94

Three basic assumptions: arbitrageurs will fight (and „penalize“) systematic
irrational behaviour at markets
 To encounter „noise trading“ or irrational pricing, arbitrage by rational investors

is only limited possible or warranted (Shleifer 2000)
 …because they have limited resources for arbitrage,
 …because arbitrage is too risky or too costly,
 …and sometimes, it might be rational to „ride the bubble“, especially for
short-term investors and to „jump off“ the trend on time
95

-Yet, it is hard to interpret the evidence (Fama):
 ECMH cannot be tested separately (alone), but only jointly with asset pricing
model
 When tested with different asset pricing models, under- and overreaction
phenomena get mitigated or even disappear
 However, robust evidence: no immediate adequate adjustment of stock prices
after earnings changes
96

Current state of research:
(a) There is mixed evidence:
• on the one hand their is evidence suggesting that the capital market reacts
immediately and correctly to new information (espec. in event studies)
• on the other hand, there is evidence on over- and underreaction.
(b) There is a kind of consensus that financial markets are generally semi-
efficient, but not always
Financial market regulators aim to reduce trading costs / torequire firms to
disclose more information / to improve enforcement, all to improve abitrage
Currently, there is no better theory than ECMH.
97

 Consequence of (semi-)efficient capital markets
 With well organized markets, investors with inside information will find it
hard to permanently beat the market
 Non-informed investors are protected by efficiency of markets (insiders find
it hard to take advantage)
 Expected return of a stock portfolio picked by a „dart-throwing monkey“
should not be worse than that of a professionally managed fund
98

Consequences for law-making
• Investors are sufficiently protected by prices in capital markets. If there are unfavorable
events, and investors may sell the security.
• If investors sell (exit): decrease in price

Management will (shall) try hard to prevent unfavorable events in the
first place.
• Therefore, at least for publicly listed companies, there is less need for investor
protection in corporate law (by voice)
• M&A law: Capital market controls management of listed companies. Active
resistance against take-over offers should not be allowed.
99

 Consequences for law-making
 supporting the market mechanism in securities law

 make arbitrage easier (lower transaction costs; make short-selling
possible)
 support institutional investments in capital markets (e.g. by pension funds)
 support private investors, e.g., by smaller costs of setting up new
investment funds
 broadening disclosure requirements & their enforcement
• e.g., inclusion of smaller companies (SME) in capital markets
• e.g., high-level, but still simple accounting standards
• however, there are costs to that (see slides on Disclosure Theory)
100

Law Econ Public Companies - Class 1 2 - Winter 2022

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Law Econ Public Companies - Class 1 2 - Winter 2022

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Jochen Bigus & Andreas Engert

The law and economics of public

Winter term 2022

Aim of the course

Introducing ourselves (Jochen Bigus)

 1994: Diploma in Business Administration, Freie Universität Berlin

 1998: Dr. rer. pol., thesis on lender conflicts

 2002: Habilitation, thesis on venture capital

 2003–2007: Professor of International Accounting at University of Osnabrück

 2007–2011: Professor of Financial Accounting at University of Bern,

 Since 2011: Professor of Management Accounting at Freie Universität

Introducing ourselves (Andreas Engert)

 1997, 1999: State exams in Tübingen

 2000: Master of Laws at the University of Chicago

 2003: Dr. jur., thesis on lender liability/debtor governance

 2008: Habilitation, thesis on capital market efficiency and the law of

 2010–2019: Professor of law at University of Mannheim

 Since 2019: Professor of law at Freie Universität

Credits & exams

Corporate law & economics textbooks

 Kraakman et al., The Anatomy of Corporate Law, A Comparative and

Resources on German law in English

• The Ministry of Justice (gesetze-im-internet.de) provides a translation of

Structure of the course

The origin of “corporate governance” (1)

• Origin of the term in the US in the 1970s(1)

Definitions of “corporate governance”

Section 1: Theory of the firm

A question worth a Nobel prize

The firm as consisting only of contracts

The firm as a nexus of contracts: the team

The firm as a nexus of contracts: the team

Alchian/Demsetz (1972), pp. 780–781:

The firm as a nexus of contracts: the team

The team as a network of contracts The firm as a nexus of contracts

The firm as a nexus of contracts: the team

The firm as a nexus of contracts: the team

• The owner of the capitalist firm:

Alchian/Demsetz (1972), pp. 783:

The team production model as a first shot at the

“Corporate governance as minimization of agency costs of equity”

Section 2: Foundations of principal-agent theory

Agency as a general theory

• Alchian/Demsetz (1972) was a special case of misaligned incentives

Agency as a general theory

Ritchie owns € 10 million invested in partnerships and a stock portfolio. He wants

A hypothetical case: full observability (1)

for many agents) 0

A hypothetical case: full observability (2)

A hypothetical case: full observability (3)

A hypothetical case: noisy observability (1)

Ritchie’s final wealth depends on Mary’s effort and 0,6

also on luck. To simplify, Ritchie’s final wealth will 0,4

A hypothetical case: noisy observability (2)

A hypothetical case: noisy observability (3)

A hypothetical case: noisy observability (4)

Even the 10% sharing contract fails to

A hypothetical case: noisy observability (5)

10% share 7 hrs.

A hypothetical case: noisy observability –

Introducing risk-bearing costs

Risk-bearing costs make it more expensive for