CORPORATIONS Shareholders November 21, 2006

1
CORPORATIONS Shareholders November 21, 2006
2
Optimal Contracts

• Optimal Size
• Corporate Governance
• Corporate Disclosure
• Insider Trading
• Insider Defences

3
Corporation Sole Shareholder

• V

Maximization of Owners Utility
Firm Budget Constraint Determined By The Firms
Profit Maximization Constraint
Vs E
Us Fs
Slope -1
F
4
Corporation Sole Shareholder

• Perfectly Competitive Firm

• Monopoly Firm

P
D
S MC1
S
MC1
SATC
SATC
PM
PPC
a1
5
Corporation Sole Shareholder

• Monopoly Firm

P
D
S MC1
Optimal Contract Cost Curve (No moral
hazard) Optimal Profit Surplus - No Agency
Costs
S
SATC
PM
6
Corporation Shareholders

• The analysis begins with a sole
  proprietor-manager who sells shares of equity to
  non-managing outsiders
• This creates a wedge between the managers
  private incentives and the incentives of the
  shareholders generally.

7
Corporation Shareholders

• .

CORPORATION (MERGED ENTITY)
Inside Shareholder (Agent 2)
Outside Shareholder (Agent 1)
8
Corporation Shareholders

• The outside shareholders cannot perfectly (or
  costlessly) observe the managers effort or focus
• Performance results are not completely within the
  managers control.

9
Corporation

• Monopoly Corporation

P
D
S MC1
Optimal Contract Cost Curve (No moral
hazard) Optimal Joint Social Surplus With
Agency Costs
S
SATC
PM
10
Corporation Shareholders

• If the shareholders could perfectly and
  costlessly observe the managers effort and the
  impact of the manager on performance results,
  there would be no agency costs.

11
Shareholders Theorem of Coase

• Agent 2 (Insider)

• Agent 1 (Outsider)

P
D
Optimal Contract Cost Curve Optimal Joint
Social Surplus Surplus With Agency Costs
S
S
PM
a1
a2
12
Corporation Shareholders
V
Maximization of Insiders Utility
Firm Budget Constraint Determined By Insiders
Profit which is partially subsidized by the
outsiders
Vs E
E Us Fs
F
13
Corporation Shareholders

• The manager, who now owns less than 100 of the
  cash flow rights, will tend to consume excessive
  perks, shirk and otherwise extract private
  benefits,
• The manager enjoys 100 of the benefit of such
  activities, but only a fraction of the cost,
  which is borne pro rata by all shareholders.

14
Corporation Shareholders

• Manager - shareholder may worry about retaining
  his position, but clearly his incentive to
  maximize firm value is reduced.
• For every dollar of firm value he adds/squanders,
  he enjoys/suffers only a fraction.
• Meanwhile his compensation is fixed. Thus,
  shirking and perk consumption (of which he enjoys
  100) will increase at the expense of firm value.

15
Optimal Contracts

• The optimal contracting model of Jensen and
  Meckling assumes that the Principal (here the
  shareholders or the board of directors) minimizes
  agency costs by minimizing the sum of the
  contracting, monitoring, bonding, and residual
  losses.

16
Shareholders Theorem of Coase

• Agent 2

• Agent 1

P
D
CMC Maximum Joint Social Surplus
S
S
PM
a1
a2
17
Optimal Contracts

• The optimal contracting model predicts that the
  managers share of firm value generally increases
  with the creation or deregulation of
  appropriation that are largely under the control
  of the executives themselves
• insider trading
• self-dealing, or
• the taking of corporate opportunities.

18
Optimal Contracts
19
Corporation Optimal Size Of Firm

• V

Point where corporation becomes too big for owner
and owner can start buying additional needs on
the open market EBoundary
Vs E
Us Equity Expansion
Path Fs
Slope -1
F
20
Corporation Optimal Size Of Firm

• Determination of the optimal scale of the firm
  with a managing shareholder and outside
  shareholders
• A corporation will expand its internal investment
  or equity to the point EB where MC gt (T A)
  allows owner to consider further growth through
  open market transactions

21
Corporation Optimal Size Of Firm
V
Point where corporation becomes too big for owner
and owner can start buying additional needs on
the open market EBoundary
Vs E
E
Slope -1 Slope -a
F
22
Corporation Optimal Size Of Firm
V
Point where corporation becomes too big for owner
and owner can start buying additional needs on
the open market EBoundary
Agency cost of having outside shareholders E
Slope -1 Slope -a
F
23
Corporation Optimal Size Of Firm
V
Expansion Path of Firm at agency costs
0 Expansion Path of Firm at agency costs A
Agency costs A
E
Slope -1 Slope -a
F
24
Corporation Optimal Size Of Firm

• The most important conflict arises from the fact
  that as the managers ownership claim falls, his
  incentive to devote significant effort to
  creative activities such as searching out new
  profitable ventures falls.
• (Jensen Meckling, p. 313)

25
Optimal Contracts
26
Corporate Governance

• In the case in which corporate value is
  independent of the form of compensation.
• If a manager receives more total compensation as
  a result of being offered a new form of
  compensation, the difference represents
  incremental appropriation.
• This is a zero-sum, fixed economic pie
  situation, so any incremental gain by the manager
  represents a transfer from the shareholders.

27
Corporate Governance

• Instituting Corporate Governance
• Outside shareholders are prepared to expend M lt A
  to reduce the consumption of perqs by the
  insider, thereby increasing V

28
Corporate Governance

• As the owner-managers fraction of the equity
  falls, his fractional claim on the outcomes falls
  and this will tend to encourage him to
  appropriate larger amounts of the corporate
  resources in the form of perquisites.
• This also makes it desirable for the minority
  shareholders to expend more resources in
  monitoring his behavior.
• (Jensen Meckling, p. 313)

29
Corporate Governance
V
Expansion Path of Firm at agency costs
0 Expansion Path of Firm at agency costs A
Agency costs A
E
Slope -1 Slope -a
F
30
Corporate Governance
V
Expansion Path of Firm at agency costs
0 Optimal Monitoring Costs M Optimal Level of
Agency Costs With Monitoring Expansion Path of
Firm at agency costs A

F
31
Corporate Governance

• A bilateral agency contract forms between the two
  (2) groups of shareholders
• When monitoring costs M, then agency costs and
  the contract itself becomes optimal
• Note that the corporation exists in a
  non-market environment, where Winter-Nearys
  bilateral agency plays a greater role
• Recalling Winter-Neary, the optimal property
  rules satisfies the following
• C11/C22(1/4) (1-a)/a
• M M
• C represents the joint investment function of
  the shareholders

32
Corporate Governance
V
Expansion Path of Firm at agency costs
0 Expansion path with optimal
governance Expansion Path of Firm at agency costs
A
Agency costs A
E
F
33
Corporate Governance

• Finding that there are agency costs associated
  with the separation of ownership and control in
  the corporation are the costs of the separation
  of ownership and control which Adam Smith (1776)
  and Berle and Means popularized.
• (Jensen Meckling, pp. 327- 328)

34
Optimal Contracts
35
Corporate Governance - Disclosure

• What disclosure is economically relevant?
• Disclosure of Hidden Information
• Prevents Adverse Selection Mismatch of Buyer
  and Seller Can arise out of inefficient pooling
• Prospectus of corporation
• Ongoing news releases
• Disclosure of Hidden Actions
• Prevents Moral Hazard Non-observability of
  management
• Insider Trading Reports Ontario Securities
  Commission publishes lists of insiders who traded

36
Corporate Governance - Disclosure

• Exchange of Information What Insiders Know
• At common law, a corporate insider did not need
  to disclose private information, relevant to the
  bilateral agency contract between the corporation
  and the shareholder

37
Corporate Governance - Disclosure

• Exchange of Information What Insiders Know
• If disclosure or non-disclosure only effects how
  the bilateral agency contract surplus is
  distributed between the parties, the information
  is distributive
• The optimal contract point remains stationary

38
Corporate Governance - Disclosure

• Exchange of Information What Insiders Know
• If disclosure or non-disclosure of information
  effects not only how the contract surplus is
  distributed, but share value as well, the
  information is productive
• The optimal contract point moves

39
Corporate Governance - Disclosure

• Exchange of Information What Insiders Know
• If the insider shareholder making a costly
  investment in productive information were
  forced to disclose this private information, the
  insider trading rule would not be optimal

40
Corporate Governance - Disclosure

• Regulation of Disclosure
• Disclosure of Hidden Information
• Prevents Adverse Selection Mismatch of Buyer
  and Seller Can arise out of inefficient pooling
• Prospectus of corporation
• Ongoing news releases

41
Corporate Governance - Disclosure

• Regulation of Disclosure
• In most jurisdictions corporations fall into two
  (2) broad categories
• Private corporations shares are closely held
  and not available to the general public
• Public corporations - Companies whose securities
  were originally distributed by way of a
  prospectus to the buying public

42
Corporate Disclosure - Directors

• Regulation of Disclosure
• Directors
• If directors use their position as directors to
  obtain a profit or other benefit for themselves,
  they are required to give up the benefit to the
  corporation.
• Derived from the common law
• Re City Equitable Fire Insurance Company Limited,
  1925 1 Ch. 407 (C.A.)
• Peso Silver Mines Ltd. v. Cropper, 1966 S.C.R.
  673, 58 D.L.R. (2d) 1

43
Corporate Disclosure - Directors

• Regulation of Disclosure
• The Ontario Securities Act requires that a public
  corporation or reporting issuer comply with the
  requirements of the statute
• Through the system of continuous disclosure,
  investors in the secondary market are assumed to
  have access to sufficient information on which to
  make informed investment decisions.

44
Corporate Disclosure - Insider Trading

• Regulation of Disclosure
• The continuous disclosure regime mandated under
  the Ontario Securities Act primarily deals with
  the publication and distribution of financial
  information on an ongoing basis

45
Corporate Disclosure - Insider Trading

• Regulation of DisclosureRegulation of Disclosure
• The effect of section 75 of the Act is to require
  a reporting issuer, where a material change
  occurs in the affairs of a reporting issuer, to
  forthwith issue and file a press release
  authorized by a senior officer, disclosing the
  nature and substance of the change, and
  thereafter file a material change report.

46
Optimal Contracts
47
Corporate Governance - Disclosure

• Regulation of Insider Trading
• Disclosure of Hidden Actions
• Prevents Moral Hazard Non-observability of
  management
• Insider Trading Reports Ontario Securities
  Commission publishes lists of insiders who traded

48
Corporate Disclosure - Insider Trading

• Regulation of Insider Trading
• Historically, as a matter of contract,
  corporations rarely prohibited insider trading
• The common law did not prohibit insider trading
  (Carlson, p. 860)
• Canada and U.S. does not prevent insider trading,
  but simply requires that the trades be reported

49
Corporate Disclosure - Insider Trading

• Regulation of Insider Trading
• Disclosure or non-disclosure should be a matter
  of contract and not externally imposed (Aivazian)
  
• This would suggest that a law leaving disclosure
  in the discretion of the informed party (common
  law) is more optimal than a law requiring
  mandatory disclosure
• This was applied by Henry Manne in 1960 to argue
  for wide open unrestricted insider trading

50
Corporate Disclosure - Insider Trading
V
Utility Curve of Insider Insider Trading
Restricted Utility Curve of Insider
Insider Trading
Unrestricted
Firm Expansion Insider Trading Restricted
Slope -1 Slope -a Slope -a
F
51
Corporate Disclosure - Insider Trading

• Regulation of Insider Trading
• If the party with the private productive
  information acquired it for free, the type and
  scope of the insider trading rule would make no
  difference to total surplus
• Legally forcing disclosure of information not
  acquired at a cost will still distort
  distribution

52
Corporate Disclosure - Insider Trading

• Regulation of Insider Trading
• This suggests an application of Coases Theorem
• Banning insider trading in effect assigns
  property rights in investment information to the
  outside investor
• Allowing insider trading, which is what the
  common law did, assigns property rights in
  investment information to the insider (Carlson,
  pp. 863, 883)
• Allows insider to trade on bad news hedging bad
  management (Carlson, p. 873)

53
Corporate Disclosure - Insider Trading

• Allowing Insider Trading With Disclosure
• Disclosure of inside trades may be cost efficient
  way of providing investors with a continuous
  stream of information (Carlson, p. 868)
• Transaction costs increase (Carlson, p. 867)

54
Corporate Disclosure - Insider Trading

• Allowing Insider Trading With Disclosure
• A principal-agency relation emerges between the
  manager-shareholder and the outside shareholders
• Moral hazard arises because insider diverts more
  of the perqs to itself, thereby eroding the
  value of the firm (Carlson, p. 869)

55
Corporate Disclosure - Insider Trading

• Allowing Insider Trading With Disclosure
• A principal-agency relation emerges
• Principals (outside shareholders) cannot
  perfectly observe the actions of agents
  (insiders)
• Insiders take more perqs or they shirk

56
Corporate Disclosure - Insider Trading

• Dennis Carlton and Daniel Fischel specifically
  focus on the role of the managerial labor market
  in reducing other compensation for insider
  trading gains.
• The Regulation of Insider Trading, 35 STAN. L.
  REV. 857, 862-63 (1983)

57
Corporate Disclosure - Insider Trading

• Dennis W. Carlton Daniel R. Fischel, argue that
  managers and firms will allocate inside
  information efficiently in the face of
  competitive markets.
• Potential managers will incorporate the
  additional benefits of insider trading into their
  wage contracts, thereby bidding their wages
  lower.

58
Optimal Contracts
59
Corporate Disclosure - Insider Trading

• Poison Pills
• Insiders resist takeovers that can enhance share
  value by issuing poison pills
• An American idea, first adopted by INCO, in
  Canada, in 1989
• Poison pills are provisions designed to make
  hostile takeovers too expensive.

60
Corporate Disclosure - Insider Trading

• Poison Pills
• When a buyer acquires a certain percentage of a
  company's stock, a poison pill is triggered,
  giving existing shareholders the chance to buy
  more stock at bargain prices, therefore diluting
  the suitor's holdings.
• In January, 2001, Ontario Securities Commission
  struck down Chapters poison pill enabling Onex
  to buy it to expand Indigo

61
Corporate Disclosure - Insider Trading

• Poison Pills
• A year later, in January, 2002, OSC did the same
  thing to Second Cups poison pill in its
  efforts to thwart a hostile takeover by Cara
  foods
• The claim is this moral hazard lowers share
  value and entrenches bad management

62
Corporate Disclosure - Insider Trading

• Poison Pills
• Some Poison pills have been eliminated by
• Securities Commission Orders
• Annual General Shareholder Meetings