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Two Cultures Shaping the Corporate Governance Debate

Two Cultures Shaping the Corporate Governance Debate. Donald G. Margotta Northeastern University. Objectives of This Research (1). Determine alternate explanations to why shareholders and managers disagree on certain corporate governance issues Takeover defenses Capital structure

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Two Cultures Shaping the Corporate Governance Debate

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  1. Two Cultures Shaping the Corporate Governance Debate Donald G. Margotta Northeastern University

  2. Objectives of This Research (1) • Determine alternate explanations to why shareholders and managers disagree on certain corporate governance issues • Takeover defenses • Capital structure • Corporate strategies • Usual explanations involve “agency” issues • Perhaps here too, but different meaning of “agency”

  3. Objectives of This Research (2) • Suggest SEC initiative to address conflicts of interest identified here.

  4. Snow, C.P. “The Two Cultures” • It was through living among these groups ... that I got occupied with the problem of what ....I christened to myself as the ‘two cultures.’ • For constantly I felt I was moving among two groups - comparable in intelligence ... who had almost ceased to communicate at all ...Snow, C.P. (1961) The Two Cultures and the Scientific Revolution, Cambridge University Press, NY

  5. Two Cultures in the Corporation • Corporate Managers • Live in a culture shaped largely by legal responsibilities and legal theory • Institutional Shareholders • The major owners of large corporations and live in a culture shaped largely by finance theory

  6. Sources of Governance Conflicts (1) • Finance Theory View (“agency issues”) • Managers attempt to enrich themselves at shareholder expense. For example: • Adoption of poison pill takeover defenses • Adoption of state takeover laws • “overly conservative” balance sheets (Motorola)

  7. Sources of Governance Conflicts (2) • Two Cultures View • Managers have a duty to work in the best interests of the corporation • poison pill takeover defenses protect the corporation • state takeover laws protect the corporation • conservative balance sheets protect the corporation • Definition of “best interests of the corporation” undefined

  8. Nature of Governance Issues (1) • Compliance Issues • Board structure, board duties • Control of potentially illegal activity • Accountability • Sarbanes-Oxley Issues (2002)- - - - - - - - - - - - - - - - - - - - - - - - - - - • None of these are discussed here

  9. Nature of Governance Issues (2) • Focus here on legal, but controversial issues • Takeover defenses (poison pills, state laws) • Corporate strategies (e.g. Kodak) • Capital structure / bankruptcy (e.g. Motorola) • Why managers and shareholders disagree?

  10. Why Focus on Institutional Investors? • There are others beside institutions who may have their own distinct cultures and conflicts with the corporation • Corporate acquirers • Risk arbitrageurs • Short sellers

  11. Why Focus on Institutional Investors? • They are largest owners of corporate stock • Their diversification is key to the discussion • They are the leaders in urging changes in corporate governance practices

  12. Diversification is Key • Diversification of institutional investors is key because it changes the way they view risk • That differentiates them from corporate managers and undiversified shareholders

  13. Diversification: Good for Investors (1) • MPT Developed by Harry Markowitz (1952) • a breakthrough in finance theory • lead to 1990 Nobel Prize in Economic Sciences • shared with co-recipients Merton Miller and William Sharpe “Portfolio Selection,” J. of Finance, 7, Number 1, 77-91

  14. Diversification: Good for Investors (2) • The impact of MPT is underscored by the fact that it has lead to indexing of most of the money in managed stock funds • Carleton et al. (1998) find that TIAA-CREF, the largest private pension fund in the U.S., indexes 80% of its domestic equity portfolio Carleton, Nelson, Weisbach (1998), “The Influence of Institutions on Corporate Governance through Private Negotiations: Evidence from TIAA-CREF,” J. of Finance, Vol. 53, August 1998

  15. Diversification: Good for Investors (3) • MPT shows that diversified portfolios are the most efficient ones • through diversification investors can eliminate virtually all company specific risk

  16. Diversification: Source of Conflict (1) • However, by eliminating company specific business risk, diversified shareholders more concerned with performance of portfolio than with individual stocks in the portfolio. • On some issues this puts diversified investors in conflict with managers who are concerned with specific company risk

  17. Diversification: Source of Conflict (2) • Managers have a legal duty to act in the interests of one corporation, not in the interests of a portfolio of stocks. • Block (1987): at least 30 states codified fiduciary duty statutes: “A director shall discharge his duties as a director... in a manner he reasonably believes to be in the best interests of the corporation.”

  18. Figure 1 Pre-Berle and Means Model Undiversified Owner-Manager Corporation Business Risk Market Risk Evolution of Corporate Control (1) 1

  19. Figure 2 Berle and Means Model Undiversified Owners Undiversified Manager Corporation Business Risk Market Risk Evolution of Corporate Control (2) 2

  20. Figure 3 Modern Portfolio Theory Model Diversified Owners Undiversified Owners Undiversified Manager Corporation Business Risk Market Risk Market Risk Evolution of Corporate Control (3) 3

  21. Other’s on Institutional Holdings (1) • Horrigan: ethical perspective. • Applies Kant’s categorical imperative • Concludes that investors may act unethically in adopting a MPT perspectiveHorrigan, James O. (1987), “The Ethics of the New Finance,” Journal of Business Ethics 6, 97-110

  22. Other’s on Institutional Holdings (2) • Deakin: diversified institutional investors are more likely to engage individual companies to try to improve performance • Black: suggests that institutional holders can play a constructive monitoring role Deakin, Simon (2005), The Coming Transformation of Shareholder Value, Corporate Governance, V. 13, Number 1, January 2005 Black, Bernard (1992), The Value of Institutional Investor Monitoring: The Empirical Evidence, UCLA L. R., V. 39, N. 4, 895-939

  23. Other’s on Institutional Holdings (3) • “In 1968, Congress directed the SEC to conduct a study of institutional investors and their impact on the securities markets.” • “Congress was concerned that the growth in securities held by banks, insurance companies, and pension funds, might result in a concentration of economic power by a few institutional traders not only over markets, but over the management’s of the companies whose stock they held, and indeed over American industry itself. Structure of Corporate Concentration: Institutional Shareholders and Interlocking Directorates among Major U.S. Corporations,” Committee on Governmental Affairs, U.S. Senate, December 1980, page 2 (approximately 3,000 pages).

  24. Other’s on Institutional Holdings (4) • Voting Rights in Major Corporations (Sen. Doc. 95-99, June 1978) and Interlocking Directorates Among the Major U.S. Corporations (Sen. Doc. 95-107, June 1978) • "Corporate Ownership and Control," Senate Comm. on Government Operations, Subcomm. on Reports, Accounting and Management. Nov. 1975, Sen. Doc. 94-246, 94th Cong., 1st Sess. Public Law 94-29, 1975. • Disclosure of Corporate Ownership (Sen. Doc. 93-62, March 1974), Senate Committee on Government Operations, Sub-Committee on Intergovernmental Relations and Subcomm. on Budgeting, Management and Expenditures,1974 • "Institutional Investor Study Report." Securities and Exchange Commission, 1971. House Doc., 92-64 92nd Cong., 1st Session. 1971

  25. Other’s on Institutional Holdings (5) • "Commercial Banks and Their Trust Activities: Emerging Influence on the American Economy." Subcomm. Print, House Committee on Banking and Currency, 90th Cong., 2d Sess., July 8, 1968. (Patman Subcommittee Study). • Temporary National Economic Committee (TNEC), "Investigation of Concentration of Economic Power." Distribution of Ownership in the Largest Non- financial Corp’s (Monograph 29), S. Doc. No. 35, 77th Cong., 1st Sess. Created by a joint resolution of Congress on June 16, 1938. "Many of the investment problems of nation arise out of the concentration of investment funds and their control in few hands." (Page 91) • “Investigation of Concentration of Control of Money and Credit." House Committee on Banking and Currency. H. Rept. No. 1593, 62nd Cong. 3d Sess. Feb. 28, 1913.

  26. Conflicts of Interest in the Corporation (1) • Manager / Shareholder • Potential conflicts long recognized • And demonstrated in illegal activities • Not demonstrated in strategies discussed here • Diversified Shareholder / Corporation • Takeover Defenses • Bankruptcy • Product Strategies

  27. Conflicts of interest (2) Diversified Shareholders and Takeover Defenses • The primary argument being made by the proponents of these proposals (anti-poison pill proxy proposal), and an argument generally supported by institutional investors based upon their proxy voting guidelines, is that poison pills entrench management and discourage takeover offers for the company.” SharkRepellant.com website, February 8, 2005

  28. Conflicts of interest (3) Diversified Shareholders and Takeover Defenses • The State of Wisc. Investment Board (SWIB) opposing Champion’s poison pill is typical of such proposals and states that a pill “effectively precludes a hostile takeover and thus allows management to take stockholders hostage.” Champion International proxy statement, 5/17/90, page 10

  29. Conflicts of interest (4) Diversified Shareholders and Takeover Defenses • Champion responded to SWIB saying a pill “enables the board to respond in an orderly and considered manner to an unsolicited bid. It puts the board in a better position to deflect unfair offers, such as coercive, partial, or two-tiered bids ... And it puts the board in a better position to negotiate a higher price for shareholders.” Champion International proxy statement, 5/17/90, page 11.

  30. Portfolio Returns: wo / w Pill Portfolio I: w/o Portfolio II: with Co. A 8% 8% Co. B 8% 8% Co. C 8% 8% Co. D 8% 8% Co. E 40% Acq’d8% Co. F 40% Acq’d8% Co. G 40%Acq’d 8% Co. H 40% Acq’d 8% A Co. I 40% Acq’d 60% A Co. J 40% Acq’d 60% A Avg: 27% 18%

  31. Conflicts of interest (5) Diversified Shareholders and Takeover Defenses • Friedman Billings Ramsey analyst David Hilal (MSFT / YHOO) • 18 of Yahoo’s top 25 shareholders– 42% of Yahoo shares – own more shares of Microsoft, which tilts their interests toward MSFT • those 18 shared holders hold 4.4 MSFT shares for every one of Yahoo • “If MSFT were to raise the offer by $3, and this negatively impacted its own shares by at least $0.68 (which we think possible), then these shareholders would be net losers” • He concludes those 18 may not want a bigger offer for that reasonWSJ, 2/28/08, “Courtship of Yahoo’s Jerry Yang,” Heidi Moore

  32. Conflicts of interest (6) Diversified Shareholders and Bankruptcy • “The bankruptcy of an airline company, for example, might be a disaster for its employees and managers who lose their jobs but a matter of indifference to its investors who own shares in other airline companies that obtain the bankrupt company's routes.” Fischel, Daniel (1985), The Business Judgment Rule and the Trans Union Case, Business Lawyer, v. 40, August 1985, 1437-1455, at page 1442.

  33. Conflicts of interest (7) Diversified Shareholders and Competitive Strategy • Explaining Kodak’s decision to devote more resources to digital photography CEO Daniel Carp said, “We are acting in the knowledge that demand for traditional products is declining, especially in developed markets.” Wall Street Journal, September 26, 2003

  34. Conflicts of interest (8) • Kodak shares dropped $4.84 per share, or 18% on the day following the announcement • trading volume of approximately 37 million shares, ten times the average daily volume, • one day loss of approximately $1.4 billion in market value based on 287 million shares outstanding. • Several analysts and large investors questioned Kodak’s strategy when rivals such as Canon and Sony were far ahead of Kodak in digital photography.

  35. Conclusion • Diversification: optimal investment strategy • Not necessarily best for exercising control because it creates conflicts of interest between the diversified shareholder and • The non diversified shareholder • The corporation itself • Management and directors of the corporation

  36. Resolution (1)? • Change fiduciary duty statutes to say directors have a duty to work in the interests of diversified shareholders (unlikely) • Identify specific issues where conflicts of interest exist with the corporation and limit voting on such issues to shareholders who do not own shares in competing companies.

  37. Resolution (2)? • SEC already makes judgments identifying “governance” issues that can be voted on • Allows companies to omit shareholder proposals if they deal with operating decisions or elections • Having the SEC make judgments on whether issues represent a conflict of interest for some would not be a significant extension of its current responsibilities

  38. Resolution (3)? • Limiting voting based on conflicts of interest is not unusual • Del. et al. disallow director shares in determining control share exemption • Ohio disallows arbs (>$250k) from vote • 35 states completely strip an acquiring person (20% owner) of their votes.

  39. Example: SEC Prop. 14a-11 (2003) • would give certain large shareholders the right to directly nominate directors • supported by large institutional shareholders such as the CalPERS (originator) • opposed by major business organizations

  40. SEC Prop. 14a-11 (2) • Example of a potential conflict of interest • Avoid largest shareholders of GM nominating directors to Ford • require shareholders who want to nominate directors, or vote, certify that they do not own significant amounts of a competitor’s stock • Impose a duty of loyalty on shareholders who seek to exercise control

  41. Dm notes • Intro: arose from corp. gov. meeting • Perhaps others will follow • Not empirical, but has empirical implications • May offend some finance people

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