CORPORATIONS – Shareholders
November 21, 2006
Optimal Contracts
•
•
•
•
•
Optimal Size
Corporate Governance
Corporate Disclosure
Insider Trading
Insider Defences
Corporation – Sole Shareholder
•
V
Maximization
of Owner’s
Utility
Vs
E
Firm Budget Constraint –
Determined By The Firm’s
Profit Maximization
Constraint
Us
Slope = -1
Fs
F
Corporation – Sole Shareholder
•
•
Perfectly Competitive Firm
Monopoly Firm
P
D
S = MC1
S
MC1
SATC
PM
PPC
a1
SATC
Corporation – Sole Shareholder
•
Monopoly Firm
P
D
Optimal Contract
Cost Curve (No
moral hazard)
Optimal Profit
Surplus - No Agency
Costs
S = MC1
S
PM
SATC
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
manager’s private incentives and the
incentives of the shareholders
generally.
Corporation – Shareholders
• .
CORPORATION
(MERGED
ENTITY)
Outside Shareholder
(Agent 1)
Inside Shareholder
(Agent 2)
Corporation – Shareholders
• The outside shareholders cannot
perfectly (or costlessly) observe the
manager’s effort or focus
• Performance results are not completely
within the manager’s control.
Corporation
•
Monopoly Corporation
P
D
Optimal Contract
Cost Curve (No
moral hazard)
Optimal Joint Social
Surplus With Agency
Costs
S = MC1
S
PM
SATC
Corporation – Shareholders
• If the shareholders could perfectly and
costlessly observe the manager’s effort
and the impact of the manager on
performance results, there would be no
agency costs.
Shareholders
Theorem of Coase
•
•
Agent 1 (Outsider)
Agent 2 (Insider)
P
Optimal Contract
Cost Curve
D
S
PM
Optimal Joint Social
Surplus
Surplus With
Agency Costs
a1
a2
Corporation – Shareholders
V
Maximization of Insider’s
Utility
Firm Budget Constraint – Determined By Insider’s Profit
which is partially “subsidized” by the outsiders
Vs
E
E* Us
Fs
F
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.
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.
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.
Shareholders
Theorem of Coase
•
•
Agent 1
Agent 2
P
D
CMC
S
PM
Maximum Joint
Social Surplus
a1
a2
Optimal Contracts
• The optimal contracting model predicts
that the manager’s 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.
Optimal Contracts
Optimal Size of
A Firm
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
Slope = -1
F
Fs
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 > (T + A) allows owner to
consider further growth through open
market transactions
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
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
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
Slope = -1
E*
Slope = -a
F
Corporation – Optimal Size Of Firm
• The most important conflict arises from the
fact that as the manager’s ownership claim
falls, his incentive to devote significant
effort to creative activities such as
searching out new profitable ventures falls.
• (Jensen & Meckling, p. 313)
Optimal Contracts
Corporate
Governance
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.
Corporate Governance
• Instituting Corporate Governance
• Outside shareholders are prepared to
expend M < A to reduce the
consumption of “perqs” by the insider,
thereby increasing V
Corporate Governance
• As the owner-manager’s 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)
Corporate Governance
V
Expansion Path of Firm at agency costs = 0
Expansion Path of Firm at agency costs = A
Agency costs = A
Slope = -1
E*
Slope = -a
F
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
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-Neary’s 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
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
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)
Optimal Contracts
Disclosure
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
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
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
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
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
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
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
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
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.
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
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”.
Optimal Contracts
Insider Trading
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
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
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
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
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
Corporate Disclosure - Insider Trading
• Regulation of Insider Trading
• This suggests an application of Coase’s 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)
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)
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)
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
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)
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.
Optimal Contracts
Management
“Defences”
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.
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 Chapter’s “poison pill”
enabling Onex to buy it to expand Indigo
Corporate Disclosure - Insider Trading
• Poison Pills
• A year later, in January, 2002, OSC did the
same thing to Second Cup’s “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
Corporate Disclosure - Insider Trading
• Poison Pills
• Some Poison pills have been eliminated
by
• Securities Commission Orders
• Annual General Shareholder Meetings