Governance and the Market for Corporate Control

John L. Teall

• Publisher: Routledge
• Year: 2014
• ISBN:
  9781317834700
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Governance and the Market for Corporate Control is a textbook for use on business courses dealing with mergers, acquisitions, governance restructuring and corporate control.

Three key features distinguish this book from competing texts. First, following up on recent developments in the corporate arena, it places a heavy emphasis on managerial compensation, incentives and corporate performance. Second, its conciseness allows for flexibility of use. Third, its coverage is broad and examines many topics including:

• significant discussions of corporate governance
• power and voting
• managerial compensation
• takeovers
• going private transactions
• corporate restructuring
• event study methodology.

As well as combining theoretical, empirical, quantitative and practitioner-oriented matter, the material in this key book provides the academic foundation necessary to ensure students' understanding of important concepts.

Chapter 1

An introduction to the market for corporate control

AN INTRODUCTION TO THE THEORY OF THE FIRM

Business organizations provide goods and services in free market economies. In the process, they seek profits from their business activities. The most common forms of business organizations in the United States are proprietorships, partnerships and corporations. A proprietorship is owned by a single individual who retains all of its profits and is responsible for all of its obligations. A partnership is jointly owned by more than one person or entity that share in its profits and obligations. These partnerships are typically treated by governments as entities separate from their partners and other affiliates; partnerships can enter into contracts, borrow, lend, own property, pay income taxes and exercise other rights just as individuals do. Corporations, also known in various countries as limited liability companies, public limited companies and joint stock companies are also treated as entities, separate from their shareowners. Many corporations issue shares of stock to be publicly traded. The focus of this book is how such companies are controlled, governed, acquired and restructured.

Understanding firms and analyzing their behavior is simplified by constructing models. The simplest model of the firm is based on a single entrepreneur or ownermanager who single-mindedly manages the firm so as to maximize his or her own profits or wealth. ¹ This model provides for the simplest analyses because the single ownermanager can be assumed to manage the firm intending to maximize his or her own wealth. However, in reality, most larger firms have more than one shareowner. Typically, most shareowners play little or no role in the management of the firm. This means that modeling firm behavior must account for the often complex interactions among the various shareowners and managers. Because actual ownership and managerial structures are more complex than the simple single owner-manager model of the firm, the classical model of the firm structures managers who are entities separate from stock holders. These managers are presumed to manage the firm on behalf of shareholder interests, even putting shareholder interests ahead of their own self-interests.² Many well-known financial models are based on this classical model.

Further complicating the governance of the firm is the myriad of other stakeholders in the firm. Any individual or organization with an interest in the firm is regarded to be a stakeholder. Such stakeholders can include shareholders, managers, employees, customers and clients, governments, public interest groups, suppliers, etc. Perhaps the most interesting developments in understanding firm behavior have been realized by modeling the firm as a nexus of contracts among factors of production, each of whom act in their own economic selfinterests.³ More generally, organizations are simply legal fictions that serve as a nexusfor a set ofcontracting relationships among individuals.⁴ In the early nineteenth century, Chief Justice John Marshall characterized the corporation as “an artificial being, invisible, intangible, and existing only in the contemplation of the law.” Note that these characterizations seem to sidestep issues concerning who owns the corporation and what its objective is. A state or government might recognize the corporate charter created by shareholders to be the central contract defining the firm. The corporate charter (discussed later) defines rights and responsibilities of shareholders. This corporation then enters into a variety of other contracts with managers, employees, suppliers, customers, etc. Many of these contracts will be formal and others might be less formal or even unwritten or implicit.

Production in decentralized economies is a complex process involving a variety of stakeholders and markets. Perhaps the most important role of markets is to provide for the allocation of capital, labor and other resources. Markets play other important roles in the economy as well. For example, they facilitate the aggregation of information that enables various stakeholders to understand the production and marketing processes. Markets provide for the monitoring of corporate performance and provide opportunities for risk sharing and speculation.

The corporate form of organization has evolved to become the dominant structure for productive activity throughout the industrialized world. Defining the corporation is important to model and understand its behavior. However, defining the corporation is not necessarily an easy task. In the United States, the I.R.S. regards the corporation to be a business organization having four essential characteristics: limited shareholder liability, unlimited life span, centralized management and transferable ownership. However, while this listing of characteristics is useful for tax purposes, it still does not define the corporation. In the academic literature, the defmition of the firm varies according to discipline. Because organizational structures vary around the world, and precise definitions are important for modeling and analysis, defining the firm for purposes of our discussion is important. For example, Alchian and Demsetz (1972) view the corporation as a contractual structure where production is the result of coordinated activities among involved parties. Alchian and Demsetz emphasize the separate natures of the parties involved in the firm and their joint contributions to production. Jensen and Meckling (1976) emphasize the contractual nature of the firm, stating “Contractual relations are the essence of the firm, not only with employees but with suppliers, customers, creditors, etc.” Fama (1980) extends this definition:

We set aside the typical presumption that a corporation has owners in any meaningful sense. The attractive concept of the entrepreneur is also laid to rest, at least for the purpose of the large modern corporation … management and risk bearing are as naturally separate factors within the set of contracts called a firm.

Thus, a business firm might be loosely defined as a contractual structure within which individuals function for the purpose of creating wealth. This definition may be somewhat vague and not entirely consistent with definitions offered in other academic disciplines (or even by other academics within the finance discipline). Nonetheless, it does capture the most important elements of what we normally think of as relating to the business firm, and we will maintain this as our operating definition for the remainder of this text.

Why do corporations exist? Can they, as separate entities engaged in production be replaced by individuals or governments? Might it be possible to eliminate corporations from the economic landscape and simply have individuals agree to cooperate and execute transactions whenever their participation is necessary? Easterbrook and Fischel (1983) argue that transactions costs, the costs of transferring assets, services or money from one person or entity to another can justify the existence of the firm:

The firm as a contractual structure specifies the responsibilities of and payoffs to each of its participants in the production and delivery process. Pre-specification of responsibilities and payoffs may be expected to reduce costs of contracting, transactions and negotiation among stakeholders. Thus, the firm saves on transactions costs. Such costs ordinarily might be related with inefficiencies associated with bargaining on each exchange or transfer. On the other hand, when the firm is created, one cannot predict the variety of potential uncertain outcomes which might be realized, implying that contractual pre-specification is not sufficient to maintain the firm; other control mechanisms must be provided for as well.

Thus, maintaining the corporation as an ongoing contractual structure enables production to continue uninterrupted by the need to negotiate terms for each and every transaction. The firm’s essential contractual relationships retain permanence. In addition, this argument can be used to support the existence of corporate voting rights that provide for variations in contractual terms as conditions change or when uncertain events make it difficult or impossible to pre-specify all contractual terms. Thus, the provision for voting is an important response to governance in an uncertain future. Klein (1983) offers a similar explanation to justify the need for corporate voting rights:

First, there are too many possible contingencies to specify in advance the responsibilities of all contracting parties, without an extreme cost. Second, contracts aren′t complete because contractual performance such as effort is prohibitively costly to measure and hence to contract.

One interesting feature of the American corporation is the limited liability enjoyed by shareholders. Why is this feature so popular? Manne (1965) suggests that this feature exists merely due to shareholder preference. However, as Jensen and Meckling point out, limiting shareholder liability does not eliminate liability, it merely shifts it to other corporate stakeholders. Shareholders must pay a price for this limited liability when selling other corporate securities such as higher interest rates on bonds. Woodward (1985) argued that limited liability exists so that it is not necessary for shareholders to know personal wealth levels and other characteristics concerning other shareholders with whom they trade and make joint decisions with. Not requiring information about other shareholders saves on transactions costs and increases liquidity. Hence, firm stakeholders make decisions affecting the corporation based only on the assets and obligations that are revealed and maintained by the corporation.

There do exist a number of alternatives to the corporate organizational structure. Among these alternatives are franchises and mutual organizations. In the franchise, the primary operational decision-maker is an owner who bears liability for operations risk; the franchiser performs a defined set of specific functions for all affiliated franchisees such as advertising, brand management, employee training, etc. This franchisee (owner or franchise operator) assumption of liability and defined set of responsibilities reduces conflicts between franchisers and franchisees. Mutual organizations such as mutual banks, are owned by their customers or employees. These and other organizational forms will be discussed later.

WHAT IS THE MARKET FOR CORPORATE CONTROL?

Corporate governance concerns how a company is managed and concerns the accountability of management and the board to its various stakeholders. Shleifer and Vishny (1997) provide a slightly narrower definition of corporate governance: “Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment.”⁵ Effective corporate governance plays a crucial role in the success of the companies while poor governance not only risks failure of the company, but can undermine financial markets and the economy as well. Corporate governance usually focuses on the relationship between the corporate board of directors and corporate management and the accountability of both to shareholders. While there is no universal standard for sound corporate governance, governance has been affected by regulation, notably, the Sarbanes-Oxley Act (to be discussed later). In addition, a number of institutions and government-sponsored task forces have disseminated their own sets of principles for sound corporate governance, including the 1992 Cadbury Report in the U.K., Calpers, the New York Stock Exchange and the OECD (Organization for Economic Cooperation and Development). Most of these and other reports can be found online and have been adapted for use by major corporations.

Corporate control refers to the ability to direct the acquisition, use and distribution of corporate assets. Such control may itself be regarded as a valued asset. The market for corporate control is simply the arena in which competitors for corporate control compete for the right to direct acquisition, use and distribution of corporate assets. Managers, owners of securities, workers, customers, suppliers and governments are all among the competitors for corporate control. The market for corporate control includes markets for managerial services and stock markets, since shares of stock generally confer rights to vote in corporate elections. For example, block holders (defined here to be shareholders with very large stakes in the firm) who wish to increase their control in the firm might simply buy additional shares of stocks to control more votes. Some block holders might wish to purchase enough shares to take over their firms, affording them outright voting control. The United States maintains very active markets for corporate control while many other countries such as Germany are more reliant on institutional monitoring or government regulation.

In the U.S. governance system, corporate control may be regarded as an asset capable of generating an indirect return. This indirect return results from the actions of controlling agents and is in the form of increased anticipated wealth to security-holders as well as private benefits realized by the controlling agents (typically managers). The sources of this indirect return include:

1 Heterogeneous expectations or abilities among competitors for control.

2 The opportunity to transfer wealth from others to oneself. This opportunity can manifest itself in the form of managerial compensation, perquisites, remaining on the job when no longer effective or in the ability to divert corporate resources to other firms in which managers might have an interest.

3 The opportunity to affect the timing, form and variability of cash flows and other benefits generated by the firm. For example, managers may wish to time dividends so as to fit their own personal tax strategies.

4 Non-monetary gains or “psychic” income (e.g. pride, etc.).

5 Monopoly power in markets for the company’s securities, markets, etc.

6 Private information that can be put to profitable use by managers.

While the first item in the above list might be a part of security...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• List of illustrations
• Series editor's preface
• Preface
• Acknowledgements
• 1 An introduction to the market for corporate control
• 2 Corporate boards, power and voting
• 3 Managerial compensation, shareholdings and performance
• 4 Corporate takeovers
• 5 Takeover valuation
• 6 Going private and other control transactions
• 7 Event study methodology
• 8 Empirical evidence on takeover activity
• 9 Corporate governance failures
• Glossary
• Notes to chapters
• Bibliography
• Index