BOARDS OF DIRECTORS AND CAPITAL STRUCTURE:
ALTERNATIVE FORMS OF CORPORATE RESTRUCTURING
Ernst Maug1)
Assistant Professor of Finance
London Business School
Sussex Place
Regent's Park
London NW1 4SA
FAX 071 - 724 3317
[email protected]
First Version: 20th December 1991
This Version: 25th January 1994
1)
This paper is adapted from chapter 3 of my PhD thesis at the LSE and I am indebted to my supervisor,
Margaret Bray, and to David Webb for numerous discussions and advice. I am also grateful to Daron
Acemoglu, Patrick Bolton, Vittoria Cerasi, Leonardo Felli, Julian Franks, Michel Habib, Oliver Hart,
Robert Heinkel, Martin Hellwig, John Moore, Kjell Nyborg and Ulf Schiller for helpful comments and
suggestions. All remaining errors are my own responsibility. I am also grateful to the Financial Markets
Group at the LSE for financial support. Earlier versions of this paper were presented (under a different
title) at seminars at the University of British Columbia, University of Frankfurt, London Business
School, London School of Economics, Stanford University, Wharton School, the 1993 symposium at
Gerzensee (Switzerland) and the 1992 congress of the Verein fü r Socialpolitik, Oldenburg (Germany).
BOARDS OF DIRECTORS AND CAPITAL STRUCTURE:
ALTERNATIVE FORMS OF CORPORATE RESTRUCTURING
Abstract
This paper discusses a model which combines internal and external control mechanisms in a
firm in which assets can have alternative uses which are in some states more profitable than the
current one. However, restructuring a firm in order to realize the gains from alternative uses
affects managers adversely since they invest in firm-specific human capital. Several institutions
which can regulate the agency relationship between shareholders and managers are discussed.
The main focus is on independent directors, who are not part of executive management. Their
function is to review and monitor contracts and managers' compensation. Independent directors
constitute a potentially better organizational form to check managerial discretion than do
constraints from debt or the market for corporate control. However, if directors' fail to exercise
control over management, takeovers or creditor control become second best solutions.
-1"The trade of a joint stock company is always managed by a court of directors. This
court, indeed, is frequently subject (...) to the control of a general court of proprietors.
But the greater part of these proprietors seldom pretend to understand anything of the
business of the company; and when the spirit of factions 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." Adam Smith (1776), p.
262.
1. Introduction
How can managers in a large corporation be held accountable, so that they are responsive to the
interests of shareholders and still have sufficient discretion over business decisions? This paper
investigates the role of independent directors from an optimal contracting perspective, and tries
to show how this institution can be understood as an answer to this question. The aim is to
contrast independent or outside directors with alternative mechanisms which regulate the agency
relationship between executive management and shareholders, such as the market for corporate
control, or debt and the control exercised by creditors. The contribution of this paper is to
analyze the functioning of corporate boards in the context of a model in which they can be
compared to hostile and friendly takeovers, managerial incentive contracts, and creditor control.
Adam Smith (1776) believed that the agency problem between owners and managers posed such
an obstacle as to make it questionable whether the modern corporation with its separation of
those who own it from those who run it is at all a viable institution. However, the separation of
ownership and control has proved to be viable, thus indicating that the implied agency problem
can be regulated efficiently. Berle and Means (1932) provided the first comprehensive analysis
of the organizational solutions that have been developed in order to balance the necessity of
managerial discretion against the hazards of unchecked power at the top of the corporation.
Although independent directors and the composition of corporate boards have always played an
important role, they have received much less attention in the academic discussion, in which
hostile takeovers and debt-contracts have taken centre stage (for a discussion of the board see,
however, Hirshleifer and Thakor (1991)). More recently, some authors emphasized internal
-2control structures as an increasingly important element (e. g. John, Lang and Netter (1992),
Jensen (1993); see also Morck, Shleifer and Vishny (1989), Shleifer and Vishny (1988)).
The model discussed below focuses on a corporate restructuring problem in order to compare
alternative governance structures. The assets of the firm have alternative uses to the current one,
and in some states it is optimal to reallocate the assets (e. g. a divestiture). In this case managers
have to write off a part of their specific human capital. Hence, the model is set up to cover two
elements of restructuring: (1) managers are potentially opposed to reallocating the assets since
they have a private stake in their current use; (2) rationally anticipated restructurings can lead to
underinvestment in human capital. In this context, independent directors are introduced as
agents separate from executive management whose main function is to monitor and renegotiate
contracts, but who are not part of the productive activity of the firm as such. In particular, they
have no vested interests in particular operating decisions.
The capital structure can be used to transfer control from managers to security holders: either to
creditors in bankruptcy, or to raiders in takeovers. These mechanisms can be effective in
reallocating resources if alternative uses of the firm's assets are more profitable than the current
one. However, they breach implicit contracts on which managers and other stakeholders in the
corporation rely when making firm specific investments, causing underinvestment if such an
interference is anticipated. Alternatively, managers can be protected from such a breach by
giving them all rights of control and a high-powered compensation plan that motivates them to
make optimal use of the company's assets. Managers can thus be protected by an explicit
contract that cannot be breached. It will be shown below that this is not only a very expensive
way to induce correct decisions, but also fails to solve the underinvestment problem.
Independent directors can serve both goals and induce an optimal use of the company's assets
without breaching implicit contracts. The argument below emphasizes the crucial role of their
independent judgement and shows that more disruptive mechanisms of corporate control
become second best solutions if independent directors become dependent on executive
management.
The modern literature on the institutions regulating the agency-relationship between
shareholders and management in large corporations starts with Jensen and Meckling's (1976)
seminal paper. Although their formal model emphasizes the role of the capital structure for
-3providing incentives, their informal discussion also stresses the control rights of different
members of the corporation in the context of their "nexus of contracts"-approach.2 This view
was further elaborated by Fama and Jensen ((1983a), (1983b)) who related the structure of
residual claims to the organisational structure of the firm. Their distinction between "decision
making" as an executive function, and "decision control" as a supervisory task corresponds to
the division of tasks between executive managers and independent directors in the model
presented in this paper. The issue of allocating powers to alter the corporate contract has already
been raised by Berle and Means ((1932), book II, chapter IV). The role of corporate boards in
critical, strategic decisions as opposed to the day to day running of the firm was also emphasized
by Lorsch and McIver (1989).
The literature on the market for corporate control is vast and will not be discussed here (see
Jarrell, Brickley, and Netter (1988) for a survey of the empirical literature and Weston et. al.
(1990), appendix A, for a textbook discussion of major theoretical contributions). The most
important aspect here is the hypothesis of Shleifer and Summers (1988) that takeover premia are
largely explained by transfers of wealth from corporate stakeholders to shareholders and a
breach of implicit contracts (see Schnitzer (1991) for a formalization of this argument).
Empirical studies have not found much evidence for the claim that such transfers of wealth can
explain takeover premia (e. g. Lichtenberg and Siegel (1990), Rosett (1990)). The emphasis in
this paper is however on a related but different problem, namely the ex ante incentives to invest
in specific skills. These incentives are impaired if implicit long term contracts are vulnerable to
breach in future reorganisations of the firm, even though the transfers caused by such a breach
may be small relative to other gains from a takeover.
The analysis of debt contracts follows a more recent approach that views debt as a mechanism
that allocates control contingent on the state between insiders (managers) and outside investors
in a world where contracts are incomplete (cf. Aghion and Bolton (1992), Zender (1991)). This
literature has opened up perspectives which view debt as a device constraining managerial
discretion (see Hart (1991), Hart and Moore (1990), Jensen (1986)). However, such a use of debt
causes problems similar to those with takeovers, since control is assumed by security-holders
2
See also Haugen and Senbet (1981) and Farmer and Winter (1986) on the subject of securities and managerial
incentive contracts.
-4who are not bound by previous contractual arrangements in the firm.
The argument in the remainder of this paper proceeds by developing the model and deriving the
first-best allocation as a benchmark case (section 2). Section 3 discusses the case where
managers are not constrained by other agents and subject only to a compensation contract.
Section 4 is devoted to the analysis of corporate boards and presents the main results of the
paper. Section 5 investigates to what extent the capital structure can serve as a substitute to
independent directors and analyzes takeovers and debt contracts. Section 6 summarizes the
ranking of alternative governance structures and concludes. All proofs are gathered in appendix
A.
2. Description of the model
Consider a project which has been undertaken in the past and yields a state contingent payoff ys
where s denotes the state of nature. The payoff ys depends on the state which can take on three
values, namely H, M, and L (high/middle/low). It also depends on the decision whether or not to
continue the project. The assets of the project have alternative uses which are not known until
after the state of nature has been revealed. Realizing the returns from alternative uses requires
major restructuring. Restructuring involves redeployment of the assets and their use under a
different management, hence either the liquidation of the assets or replacement of the manager.
The returns from restructuring are denoted by Ls (then ys=Ls); if the project is continued it yields
xs (then ys=xs). All values are expressed in prices of stage 1. The project is summarized in the
following diagram:
Figure 1
1.
2.
3.
4.
5.
time
h
s
decision
ys
-5-
The value from restructuring Ls becomes available after the first period return has been realized.
The firm is run by managers who negotiate a compensation-scheme with the owners at the initial
stage 1, run the firm and make human capital investments. The human capital investments can
be either general or specific to the firm. The investment in human capital is not modelled
explicitly here. This assumes that the total amount of investment in human capital (general plus
specific) is given, so that only the choice of the specificity of human capital needs to be
considered. This specificity of human capital is represented by one variable h, where h lies in the
closed unit interval and can be thought of as an index. The following assumption describes the
two important elements of the technology. Firstly, the specificity of human capital h increases
the probability of success of the firm, i. e. h increases the level of expected profits. Secondly,
returns are determined by nature and by the decision how to use the assets.
Assumption 1 (Production):
(i) ys depends on the continuation decision:
(ii) The specificity of human capital determines the likelihood of more profitable states:
where
(iii)
is increasing and concave.
and
,
.
.
Parts (i) and (ii) of assumption 1 summarize the previous discussion and impose some regularity
conditions. Note that the probability of the low state L is independent of h. This assumption
facilitates proofs and is for convenience only. The defining characteristic of states is the ranking
of continuation profit levels xs in (iii).
-6-
Managers negotiate contracts with the original security-holders. These contracts specify
payments
contingent on profits. The managers do not care about the specificity of their
human capital investment h as long as the project is continued, and the effort for investing in
some kind of human capital does not need to be considered here. However, investing in a high
level of firm-specific human capital implies that their value in the outside labour-market has
decreased. If the project is discontinued, they suffer a utility loss D(h) which increases in h. One
interpretation is that managers have lower career-prospects if the human capital they have
acquired is specific to the firm rather than of general applicability. Alternatively, the utility loss
may be viewed as a search cost that managers incur if they have to look for new employment.3
Yet another interpretation is that managers' aversion to reallocating the assets is related to the
commitment and skill they devoted to the project's development. The following assumption
describes managers' preferences:
Assumption 2 (Utility):
Managers maximize expected utility. Their utility is given by:
and
where D’
, D’’
.
Here E(.) denotes the expectations operator. The assumption states that the disutility from a
closure decision, D(h), is progressively increasing in the specificity of human capital: the more
specific managers' human capital, the more they are locked into the firm and the higher is their
interest in preventing its closure. Assumption 2 also implies that managers are risk neutral. Then
their objective can be rewritten as:
,
3
I am grateful to Robert Heinkel for this interpretation.
(1)
-7where P(l) denotes the probability of closing the project under policy l and l denotes the set of
states in which the project is closed (e. g. l={L} indicates that the it is closed if and only if s=L;
then
; similarly, if
, then
). The right to decide about the use
of the assets can be assigned to different parties (insiders and outsiders) according to the
ownership structure of the firm. The following assumption further defines states and is made in
order to introduce the possibility of inefficient decisions about the use of the assets:
Assumption 3 (States):
(i)
(state H)
(ii)
(state M)
(iii)
(state L)
(iv)
)<
(
In state H, nobody would consider closing a project. In state M, it is privately but not socially
optimal to restructure since the gains do not exceed the pecuniary equivalent of the utility-loss
they inflict on managers. In state L, it is privately and socially optimal to redeploy the assets.
Only these three situations matter since they describe the conflict of interest between owners and
managers; hence, there is no essential loss of generality involved in restricting the analysis to
three states. Outsiders who make decisions contingent on pecuniary returns only will restructure
whenever L - x>0 even if this difference is relatively small. Assume that h is observable but not
contractible. Then managers cannot insure themselves against this by writing compensation
payments into their contracts contingent on h. The only way in which they can protect
themselves is by investing in general human capital in order to limit their exposure to
restructuring-decisions taken by outsiders (i.e. keeping their options open on the managerial
labour market). This will, however, make the project less successful. Moreover, condition (iv)
ensures that the restructuring gain is sufficiently important relative to potential efficiency-gains
from human capital investments to make closure in state L attractive. The timing of the model is
displayed below:
-8Figure 2
1.
2.
3.
4.
5.
time
Owners determine
governance structure:
capital structure
managerial contract
decision-rights
1.
Manager chooses h.
State s revealed.
Party in control
decides on project
closure.
Payoffs ys realized;
parties paid according to
contracts; managers paid
(ys).
Equity-holders determine the governance-structure of the firm by simultaneously
choosing the capital-structure, the compensation-scheme for managers and the allocation
of decision-making rights.
2.
Managers decide on the specificity of their human capital h.
3.
Nature moves and selects the project-relevant state s. The state s is immediately revealed
to all parties.
4.
Control is assigned according to contracts. The party who is in control decides whether
to liquidate or not.
5.
Payoffs ys are realized, dependent on the states of the firm and the restructuring decision.
All parties are compensated according to their contracts; managers receive
.
The next proposition derives the first-best allocation (l*, h*) as a benchmark for further results. It
is defined from the maximand:
(2)
Recall that P(l) denotes the probability of redeploying the assets under policy l. The first term
gives profits as a function of h and follows immediately from assumption 1. The second term is
the expected disutility managers suffer (cf. assumption 2 and equation (1)) which is obtained
from multiplying the extra disutility of closing, D(h), by the probability of closure. The
maximand in equation (2) admits two interpretations: either it is the utility-maximizationproblem of an insider who owns all residual claims to the firm, or it is the profit-maximizationproblem of an owner under the assumption that h and l are contractible at stage 1. The following
proposition characterizes the first-best:
-9-
Proposition 1 (First-best):
The solution of program (2) which characterizes the first-best
is to liquidate a project if and only if it is in state L. The first-best value
is
interior and solves:
(3)
The first-best solution is also unique.
I assume throughout the paper that wealth-constraints are sufficiently severe such that outside
finance is required and control has to be delegated. The question then arises as to which
structure of decision-making, determined by the organizational form (including the managerial
contract) is optimal from an efficiency point of view. This will be analyzed in the rest of this
paper.
3. Explicit contractual protection: pure managerial control
Proposition 1 in the previous section gives the allocation for the hypothetical case that contracts
can be contingent on h. However, the maintained assumption of this paper is that h is observable
but not contractible. This section develops another benchmark by investigating the impact of
pure managerial control. Managers are fully protected by an explicit contract if they exercise all
control rights over the use of the assets. Then the only way to obtain the gains from restructuring
is a compensation-scheme that gives managers an incentive to close the project in the low state.
Assume all decision-making is delegated to managers. Owners then offer managers a contract
contingent on profits which is constrained by the following assumption:
Assumption 4 (Managerial contracts):
(i)
Managers' compensation can be any contract
subject to the condition that it cannot involve negative payments in any state, i. e.
for all
.
- 10 (ii)
Managers have zero wealth and a reservation-utility from alternative
employments which gives them zero expected utility at stage 1.
This assumption ensures that managers will not be made residual claimants; since their utility is
linear in wealth, this must be ruled out, otherwise the solution of the problem would be trivial.
Assumption 3(iv) ensures that owners will never forego the gain from restructuring in state L
only in order to improve efficiency. Hence, they have to induce managers to close the firm in
state L by an appropriate compensation-payment. Denote by
the degree of specificity of
human capital for the case of explicit contractual covenants, and by r the rent managers extract,
defined as the difference between their expected utility and the utility of their outside option.
Proposition 2 (Managerial control):
(i)
The optimal managerial contract in the case of explicit contractual protection of
the manager has:
(4)
,
where
and
satisfy:
(5)
from managers' first order conditions. This induces restructuring if and only if
s=L and does not implement the first-best efficient solution characterized in
proposition 1; in particular,
(ii)
.
Managers obtain a rent which is strictly positive, namely:
(6)
- 11 Hence, managers receive a bonus µ(xH) in the high state and severance pay µ(LL)=D(hE) in the
low state when they redeploy the assets. In view of proposition 2, profits ΠE in the case of pure
managerial control are:
(7)
Hence, in setting µ(xH) owners trade off the benefit from higher profits of the firm against the
rents they have to pay managers in order to implement a certain value for h. Since these rents
increase in h, a suboptimal value hE < h* is chosen. The weakness of protecting managers by
explicit contracts is that managers do not sign an employment contract contingent on h and have
to be motivated by a bonus payment µ(xH) in the high state. The outcome reflects the
characteristics and tradeoffs of a standard moral hazard situation. The next section introduces an
ownership-structure which overcomes this problem.
4. Independent Directors
This ownership-structure introduces another agent which I call a supervisory board of directors
or simply independent directors. For the purpose of this argument it is immaterial whether
independent directors are a part of a unitary board, or form a separate supervisory board in a
two-tier system. Directors do not invest any human capital themselves and can be given an
incentive scheme which induces them to maximize the firm's total net profit. They consider only
the pecuniary returns of the firm according to their contracts. Denote directors' compensation by
δ. Their contracts are restricted:
Assumption 5 (Directors):
(i)
All compensation-schemes for directors must be linear
payments which may be contingent on the profit of the firm and on managers'
compensation. They must be of the form:
(8)
(ii)
Directors maximize expected utility given from
(iii)
Directors have zero wealth and an outside option which gives them zero
expected utility at stage 1.
.
- 12 -
The restriction to linear contracts and to equal coefficients on ys and - is for convenience only:
since the next proposition shows that the first-best can still be implemented, this restriction is not
binding. Directors' motivation can be understood in two ways. Firstly, they may be obliged to
hold γ shares of the firm which entitles them to a fraction γ in the dividend
.
Alternatively, they may be under a fiduciary duty to shareholders to act on their behalf. In this
context such a duty would oblige them to maximize dividends.4 Under this ownership-structure,
managers have the right to decide about the use of the assets. Directors have the right to review
managers' salaries. For clarity, denote the original managerial contract agreed at stage 1 by
and the compensation offered by directors by
. Directors can influence closure
decisions by offering managers additional compensation for divesting. Hence, managers
negotiate with directors over the closure decision and over adequate compensation.
4.1 Full control by independent directors
In the first version of this ownership-structure considered here directors have all the bargaining
power when they negotiate the adequate compensation for compensating managers. Whenever
directors want to redeploy the assets they offer managers a compensation
in return for their
consent to this decision. The extensive form of stage 4 (see figure 2 above) is then the following
stylized bargaining game:
(a)
directors offer managers a compensation
subject to their consent to asset-reallocations;
(b)
managers accept or reject this offer;
(c)
If they reject, the original managerial contract is implemented, managers receive
and no assets can be sold. If they accept, they receive
and directors decide
whether to liquidate or not.
The firm is fully equity-financed and equity has no voting rights. Proposition 3 describes the
allocation:
4
Cf. Hart (1992) for a discussion of fiduciary duties.
- 13 Proposition 3 (Directors):
Assume control is delegated to managers and directors such that
directors make decisions subject to managers' consent, i. e. directors retain all
bargaining power. Managers receive a transfer
in state s=L and zero
transfers in the other two states. There are no profit-contingent payments, i. e.
for all
. This mechanism implements the first-best.
The renegotiation-mechanism implements the optimal restructuring-policy since it effectively
insures managers against ex post expropriation by security holders who have no right to interfere
at this stage. Managers do not care about asset reallocations when they make human capital
decisions because they know that they will always be adequately compensated. This has the
consequence that directors take into account all benefits and losses from restructuring, not just
pecuniary payoffs. Hence, they redeploy assets only in those states where this is optimal.
The proof shows that given a certain level of human capital specificity and given restructuring is
desired, the optimal managerial contract may specify the same compensation as will be
negotiated between directors and managers (in that in both cases managers obtain D(h) if s=L,
although this relates to different values of h in equilibrium). However, they are the same only in
equilibrium; the payments under a managerial contract do not cancel against managers' disutility
identically as under the director-mechanism. There
renegotiation-subgame starting with some value
for all h, i. e. for every
. The incentive-implications of the two
solutions to the agency-problem are very different for this reason. The key difference is the point
at which compensation is offered to managers. If managers have an incentive contract which is
negotiated at stage 1, they choose h after state-contingent payments have been fixed, which can
then not depend on their choice of h. In the director-mechanism, the compensation is determined
later and takes h into account. Therefore, even though the payment-levels are the same, the way
they are set implies different incentives for managers. This result is a robust feature of
renegotiation under symmetric information (cf. Hermalin and Katz (1991) for a proof in a
general principal-agent contract). Monitoring by a second agent who is subject to an explicit
contract is a substitute for a complete or comprehensive contract, which is by assumption not
available here.
- 14 Note that all three characteristics of directors are important for the result:
-
directors have no vested interests in particular operating decisions. In particular, they
have no specific human capital at stake in case of project closures.
-
directors' aim is to increase pecuniary payoffs to shareholders only. They may be
motivated explicitly by shareholdings, or by the possibility of litigation enforcing their
fiduciary duties.
-
directors have all the negotiating power vis a vis managers.
The first characteristic may be regarded as the definition of an independent director. Directors
whose human capital is so specialized that it gives them a stake in a particular decision are not
independent and should be classed as executive management. The second characteristic is
controversial since some practitioners argue that independent or outside directors should not
hold shares or participate in incentives plans. The last feature presents the strongest assumption
of this section. Its relaxation is the subject of the next section.
4.2 Managerial negotiating power
The positive result about implementation of the first-best with the director-mechanism is
obviously extreme as it depends on all bargaining-power being given to directors. However, as
directors need managers' consent in order to force restructuring and because they have to
renegotiate their salary, managers may be to some degree successful in pressing for a higher
compensation than is needed to make them just indifferent between continuation and closure of
the project. This section therefore analyzes the same ownership-structure as the previous section
under alternative assumptions on bargaining power. Hence, the extensive form of stage 5 of the
game is now:
(a)
Directors and managers bargain over the decision to close the firm and over managers'
salary.
(b)
If they reach an agreement, managers receive a transfer
and implement the agreed
restructuring decision. If they do not agree managers decide and do not receive any
transfer.
- 15 -
The bargaining outcome is determined from:5
Assumption 6 (bargaining):
If managers and directors enter a bargaining game at stage 4,
then the outcome is determined according to a generalized Nash-bargaining solution
which gives directors bargaining-power 1-α and managers bargaining-power α.
It is almost impossible to prescribe in any kind of explicit contract the bargaining-positions of
insiders who work in close relationships, let alone formalize such a bargaining-process. The
approach advocated here is to avoid any speculation about what the give and take in the relations
between directors and managers is, and to take "bargaining power" as exogenously given rather
than to make it part of the formal model. The determinants of the relative positions of directors
versus executives are discussed in the concluding section. From assumption 5 (i) (contracts for
directors), directors receive in case of closure
Similarly, managers get
and in case of no closure
in case of continuation and
the maximand for the generalized Nash Bargaining game is, assuming
.
in case of closure. Hence,
:
(9)
Then:
(10)
It is intuitive that bargaining power (i. e. α > 0) should not matter if it is not in some sense "too
large". This is expressed in the following proposition.
5
For a textbook treatment of the generalized Nash bargaining-solution see Binmore (1992), ch. 5. The cooperative solution chosen here is directly related to non-cooperative bargaining solutions and the solution below has
an interpretation in terms of alternating offer games; cf. Osborne and Rubinstein (1990), ch. 4 for a discussion.
- 16 Proposition 4 (Bargaining Power):
(i)
Suppose assumption 6 holds and managers have
bargaining power α. Then the firm will be closed if and only if it is in state s=L and
directors award managers a transfer
contingent on α and h given by:
(11)
and
(ii)
in all other states.
If α>0, the director-mechanism does not implement the first-best anymore. However,
there exists a threshold value
, s. t.
implies that the director-mechanism still
dominates pure managerial control.
(iii)
There exists a second threshold level
with the property that
implies that
managerial control dominates the director-mechanism.
It may be noted that the minimum payment which managers receive if they have no bargainingpower (α=0) is D(h) as in proposition 3. However, if they have bargaining-power, they receive
not only a compensation for their disutility but also a fraction α of the surplus. If α=1, they
obtain the whole surplus, a standard result for Nash-bargaining-games. Hence, proposition 4
implies that directors with bargaining power less than
are worse for the firm's profits than
delegation to managers "no strings attached".
The intuition behind the third part of the result is that directors who do not have sufficient
bargaining-power against management do not only become less useful, but positively harmful
since they worsen managers' incentives to choose specific human capital investment. This is
somewhat surprising because managers' compensation in restructuring-states increases with
their bargaining-power. Since compensating them sufficiently for their utility-loss in
restructuring-states was the main force behind proposition 3, one might expect that an even
larger compensation should only give them higher rents, but leave their investment-decision
unchanged. Inspection of equation (11) reveals why this is not the case. If managers have vetobut no bargaining-power (α=0) they receive
. The "pie" to be split is the net gain
from restructuring, i. e. the pecuniary benefit minus the amount necessary to compensate
- 17 managers' utility-loss:
. This "pie" is shrinking for higher values of h. If α=0,
managers are not affected by this. However, the higher their bargaining-power, the higher the
weight the size of this net gain has in their decision about h. Eventually, for high values of α,
their incentives, i. e. their responsiveness to a higher value of
, approach those of the case
where they receive no compensation since their compensation becomes a constant. This is so
because if managers have all the bargaining power, they receive
independently of the h
they have chosen before. This was shown to lead to inefficiencies in proposition 2 above. More
formally, first order conditions for choosing h in the director-mechanism are:
.
(12)
This coincides with the expression for managerial control if α=1; cf. equation (5) above. Pure
managerial control is better than the director-mechanism because with the bargaining power of
managers becoming large, the director-mechanism is similar in terms of incentives but transfers
are smaller if they can be fixed in a managerial contract. This is therefore always cheaper from
the point of view of owners. It is this double hazard which directors with low bargaining-power
introduce: they award excessive salaries to managers, causing a direct loss to security-holders,
and they distort incentives, thereby causing an indirect loss in the form of productive
inefficiencies. The two taken together lead to the uniform verdict expressed in proposition 4.
5. Control and capital structure
The previous section has shown that independent directors have the potential to implement the
first best if their negotiating position is very strong, otherwise an independent supervisory board
may be a mixed blessing. Under such circumstances, managerial discretion may be checked by
creditors or raiders. The circumstances under which they gain control of the firm are determined
by the capital structure and the corporate charter. These mechanisms are discussed in this section
in order to investigate alternatives to the internal control structures analyzed above. The first
subsection shows how leverage can induce creditor control, whereas the second subsection
focuses on the market for corporate control as an external disciplining device.
- 18 5.1 Debt and creditor control
Assume now that ownership rights can be transferred to security-holders by using profitcontingent debt. The latter describes a financial contract which specifies that control of the firm
is transferred to creditors if profits fall below a certain value (see below). If creditors have the
right to liquidate, they will always liquidate at t=1 if L - x>0, i. e. they will only consider
pecuniary returns. Suppose the face value of debt F satisfies
. Then in state L, the
firm is bankrupt and creditors liquidate the assets after gaining control. In state M the manager
can issue junior debt or equity to raise an amount F in the market and pay off creditors so that
the firm is not forced into bankruptcy. Another view of bankruptcy leaves the manager formally
in control in state L. Then managers close the project themselves and use the restructuring
proceeds to pay off debt. This leads to the same allocation and is equivalent for the benefit of
this discussion. The following proposition presents the main result on creditor control; hD
denotes the level of h chosen by the manager if owners have chosen the optimal debt level.
Proposition 5:
(i) Two debt-policies can be optimal for owners:
(1) l={L}: the firm will be closed in state s=L;
(2) l={M, L}: the firm will be closed in states s=M and s=L.
(ii)
This solution gives owners higher profits than pure managerial control and is
dominated by the director-mechanism as characterized in proposition 4.1; the
solution involves underinvestment in specific human capitals:
.
Even though owners can reduce the rent managers can extract relative to pure managerial
control, investment in specific human capital remains inefficient. Recall from proposition 2 that
under managerial control managers obtain a strictly positive rent (given by equation (6)). Hence,
whenever owners determine the optimal debt-policy, they have to observe two constraints: first,
managers' incentive compatibility constraint which requires:
.
(13)
- 19 and second their participation constraint which amounts to
(cf. equation (A 16) in
appendix A). From assumption 3(ii), it can never be profitable to liquidate in state s=M if this
requires an additional payment
to the manager in that state. However, if managers
receive a strictly positive rent if l={L}, then it is possible that liquidating in state s=M as well
only reduces their rent and owners gain
minus the efficiency loss from a higher
probability of project closure. Since no assumption on the parameters of the model prevents this
from being positive, l={M,L} is possibly an optimal policy and debt leads to excessive project
closures relative to the first-best criterion. Debt is better than managerial control because it
reduces rents received by managers. Note that this is a purely redistributional argument.
Allocative efficiency is generally reduced by too frequent restructurings since h is reduced
further below its first-best value. The next section illustrates how voting equity, like debt, can
serve to implement an alternative system of checks and balances.
5.2 Takeovers and the role of the corporate charter
Assume the firm is fully equity financed and at least a certain part of the outstanding shares have
voting rights. The number of outstanding shares is normalized to 1. Suppose after stage 3 a
potential raider can take over the company and bid for the voting rights. Moreover, assume the
raider can acquire a fraction φ of the firm at the current market price PM, where PM is the ex
dividend value of the shares at stage 3 before a bid is announced. Evidently, bidders are only
interested in pecuniary payoffs, leaving managers vulnerable to interventions by outsiders who
do not take into account the loss they may suffer if their human capital is depreciated. Consider
therefore the inclusion of takeover defenses in the corporate charter which owners decide at the
first step of the game. Hence, stage 4 of the game described in section 2 has the following
extensive form:
(a)
A potential raider decides whether to take over the firm or not. If not, managers decide
about the use of the assets.
(b)
If the raider decides to take over, he purchases φ shares on the stock market at the
current market price PM and announces the conditions of the bid.
(c)
Managers decide whether they use takeover defenses if such defenses are available to
them.
- 20 (d)
If managers defend the bid effectively, they stay in control and decide about the use of
the assets. If they do not defend the bid, shareholders decide whether to tender their
shares.
(e)
If the bid succeeds, the raider gains control and decides how to use the assets. Otherwise
managers stay in control and make decisions.
Then only states where
are candidates for takeovers. The raider will close the firm,
redeploy the assets and obtain Ls. Hence, the post announcement value of the share is Ls.
Shareholders will tender their shares only if the raider offers Ls, otherwise they would prefer to
stay as minority shareholders in the firm and the bid would fail.6 Denote by q the probability that
a takeover bid is made, which is also the market's expectation of a bid in equilibrium. Then,
before the announcement of the bid the value of the company and the market price of the share
is
. The raider's profits are:
.
Hence, the raider will take over whenever
which requires
(14)
. Note that R>0 implies
q=1. This cannot be an equilibrium since q=1 implies R=0 and PM=Ls. Hence, the unique
equilibrium has R=0 and q=1 so that shareholders obtain Ls whenever Ls>xs. This gives the first
result on hostile or undefended takeovers:
Proposition 6 (Hostile takeovers): If takeovers are undefended, a bid will always be made
whenever s=M or s=L. Managers receive only a payment if the state is high (
) and the outcome is exactly as if l={M, L} is implemented with debt in
proposition 5.
Takeovers lead to excessive asset reallocation because this is optimal after stage 3 when the
decision about human capital is sunk and managers cannot bribe potential raiders. This situation
provides a rationale for takeover defenses which give managers some control over the takeover
process. There are numerous strategies to defend bids.7 Since takeover defenses are not the focus
6
This is familiar from the analysis of the free rider problem, cf. Grossman and Hart (1980), (1981).
See Weston et. al. (1990), ch. 20 for a textbook treatment of takeover defenses, and Herzel and Shepro (1990),
ch. I.8, for a discussion from a legal point of view.
7
- 21 of this discussion, no analysis of the mechanics of different devices is undertaken here. Assume
for the remainder of this section that managers have access to some effective defense, e. g. a
poison pill, and that a raider can only acquire control of the assets by obtaining managers'
consent for the transaction. Evidently, this is only possible if the raider offers a compensation
which at least offsets their disutility D(h). Hence, the raider's profit is now:
.
(15)
It follows immediately from (15) that the unique equilibrium of the takeover subgame (stages 4,
5) is different from the one in proposition 6: if q=1, R= -D(h), hence no bid will be made.
Moreover, if φ is sufficiently large and q=0, then
is positive and the
unique equilibrium is in mixed strategies. The complete result is given in the following
proposition, where the subscript FT refers to the allocation with friendly takeovers.
Proposition 7 (Friendly takeovers): Suppose managers can obtain a severance payment
and can use takeover defenses. Then hostile takeovers will not take place. Friendly
takeovers take place only if s=L and a bid will be made if s=L with probability:
(16)
Managers receive severance pay equal to
in the event of a takeover, but no
other salary payment and they are indifferent about h.
; however
if
can be larger or smaller than
.
The crucial element which limits the probability of a takeover is the fact that the costs of the bid,
namely the severance payment to the manager, are born privately by the raider. The raider can
only profit on the fraction φ he owns before announcing the bid, since the fraction 1-φ must be
acquired at a post-announcement price
. On this `toehold` he can only profit if the market
anticipates a takeover with probability q<1. This is so because the stock price before the bid
includes a takeover premium
above the value of the firm under the incumbent
management. However, if q=1, then PM=Ls and the gross profit from a successful takeover is
zero and the net profit negative, since bids are now costly. Hence, the potential bidder must
- 22 randomize and keep the stock market guessing about the probability of a takeover. Then the
takeover premium in the market price will be reduced, leaving some room for the raider to
recover the costs of the bid. Hence, the takeover defense is successful in preventing too frequent
restructuring and the resulting underinvestment in specific human capital. However, defenses
bring about the opposite problem: there are too few takeovers since q<1 in equilibrium: with
probability 1-q there is no takeover in the low state. If the likelihood of a takeover is sufficiently
low, then the underinvestment effect is also reversed. Indeed, if φ is small enough and
there are no takeovers and it is optimal to have
. The allocation with
,
,
is
inferior to the allocation with a managerial incentive contract described in proposition 2. At
some point it would obviously be advantageous to induce closure by giving the manager the
incentive contract described in proposition 2. The details of the interaction between managerial
incentive contracts and friendly takeovers are not pursued here. Similarly, the allocation can
improve if the costs of a takeover can be recaptured with exclusion devices as discussed in
Grossman/Hart (1980). This possibility relies on very restrictive assumptions and is further
analyzed in appendix B.
An equilibrium in mixed strategies is not always very intuitive. Note, however, that the
equilibrium in proposition 7 can be understood in terms of a pure strategy equilibrium of an
incomplete information game.8 Suppose there are different types of raiders with different
valuations of the assets. Then the stock price PM will be such that it is profitable for those raiders
who have a high valuation to bid, whereas those with valuations below a certain threshold will
not bid. This setup has been studied by Shleifer and Vishny (1986) and Hirshleifer and Titman
(1990), whose analysis provides therefore another motivation for the mixed strategy equilibrium
described above.
This whole section confirms an intuition already stated by Shleifer and Summers (1988): if
managers rely on an implicit, long-term contract with the firm when they make far-reaching
decisions, the possibility of hostile takeovers has a social cost. It was shown here that friendly
takeovers provide an alternative, even though under somewhat restrictive assumptions, and that
the associated and potentially large separation payment serves an efficiency-enhancing purpose.
8
See Fudenberg and Tirole (1990), pp. 233-234 for a statement of the purification theorem.
- 23 6. Discussion and Conclusion
This paper has investigated a model in which the assets of the firm have alternative uses which
are sometimes more profitable than the current one. Managers of the firm invest in firm specific
human capital which becomes worthless in case the firm is restructured and projects closed.
Human capital decisions are not contractible, so that managers are given either all residual rights
of control, thus protecting them from outside interference, or they have to rely on implicit
contracts with the firm which are sometimes breached. In this situation the allocation can be
improved if rights of control are delegated to two agents. The first is executive management
which is in charge of the day to day running of the firm, invests in specific human capital, and
has primary control over business decisions like the use of the assets. The second agent is a
supervisory board or a group of independent directors whose main instrument of control is the
discretion they can exercise over managers' remuneration. This gives them influence over
restructuring decisions, which can then be facilitated by making appropriate compensation
payments.
The analysis has also provided a ranking of the alternative governance structures discussed
above (cf. figure 3). Here the labels "Strong" and "weak" refer to directors" bargaining position
vis a vis executive management. Independent directors can secure gains from restructuring and
simultaneously sustain the commitment of the company to implicit contracts. However, if
directors are weak, managers' severance pay is largely determined by their bargaining strength
and they are able to extract excess compensation payments in restructuring. Then shareholders
lose twofold: directly, since they lose the extra compensation paid to managers, and indirectly,
since managers' pay is determined by their bargaining position and independent of their
performance variable, namely investment in firm-specific human capital. As a result, weak
directors are the worst possible solution to regulate the agency problem. Corporate raiders or
creditors can force restructuring if they obtain control of the company's assets and secure the
restructuring gains for shareholders. However, they make managers vulnerable to losses of their
specific human capital, thus causing underinvestment, an effect that is impounded into the value
of the company. These institutions associated with the capital structure are nonetheless second
best solutions that improve on unconstrained managerial control of the corporation: explicit
contractual protection is no alternative to implicit contracts that can be breached.
- 24 -
Figure 3
Strong Directors
>
Takeovers, Debt
>
Managerial Control
>
Weak Directors
The formal analysis has taken directors' bargaining power vis a vis managers as exogenous.This
is useful in the context of a model, but should not be taken to suggest that the determinants of
bargaining power or different degrees of directors' independence cannot be distinguished.
Lorsch and McIver (1989) identify in particular (1) the nomination process of directors (selected
by the CEO or an independent committee), (2) their legal accountability, and (3) their access to
independent informational sources. Similarly, the Cadbury committee (1992) in the UK has
stressed these elements and the separation of the functions of CEO and chairman. Another
element is emphasized by Baysinger and Butler (1985), who found that firms perform on
average better if their outside directors are independent from the firm and do not represent
organisations with financial or business relationships with the firm. Weisbach (1988) also found
evidence for outside directors improving corporate performance.
The analysis has shown how independent directors can be understood as an institution that
regulates the relationship between shareholders and managers in a world where contracts are
incomplete. They are different from executive management since they do not participate directly
in the productive activities of the firm, and accordingly do not invest in firm specific human
capital. However, even though they act on shareholders' behalf, they are not like a large majority
shareholder who exercises all residual rights of control, since directors have to respect managers'
prerogative over the allocation of assets. If a large shareholder exercises all residual rights, he is
more akin to a corporate raider, so that the result on hostile takeovers applies. However,
- 25 directors are more similar to a large shareholder or a group of large shareholders who do not
exercise all residual rights of control and who have delegated the rights to control the assets to
the manager. This would then resemble a closely held company in which shareholders can
negotiate directly with managers. Independent directors can thus be seen as an institution that
permits the same kind of negotiation in a widely held corporation in which shareholders cannot
influence production decisions directly. The important insight is that in widely held companies
control has to be delegated to two institutions or agents: managers, who are in charge of the day
to day running of the firm, and directors who monitor and review contracts and use this right as
an instrument to influence business decisions.
- 26 Appendix A
Proof of proposition 1:
Suppose the insider has chosen h before states were realized. Then in each state s the
project will be liquidated if and only if:
.
(A 1)
By assumption 3, this is only the case for s=L. Hence either I={L} or I=Ø. From
assumption 3(iv), the gains from liquidating in state L outweigh the costs, hence I={L}.
Then first order conditions are then given by equation (3) in the text (from equation
(2)). By assumption 1(ii), this solution is interior. The maximand (2) is strictly concave
from assumptions 1(ii) and 2. Hence, the unique solution is characterized by equation
(3).
Proof of proposition 2:
(i) For any optimal managerial contract μ(ys) is zero for all levels of profits in which it
does not serve to either induce managers to liquidate a project, or to provide them with
an incentive to increase h. Payments in any other state would be pure transfers from
owners to managers without any benefit for the owners. Suppose that owners want to
implement hE and want managers to liquidate in state s. Then μ(xs) and μ(Ls) must
satisfy:
(A 2)
which implies:
in the optimal contract since owners want to
minimize transfers. However, a necessary condition for such a transfer to be optimal is
that it increases profits for owners, i. e. if:
(A 3)
- 27 which only holds for s=L. Together with assumption 3(iv), this implies that l={L} is
optimal and describes the optimal managerial contract for implementing it.
Now assume I={L}. Then managers have utility:
(A 4)
Owners solve:
(A 5)
s. t. the first order conditions of the manager, which are:
.
This gives immediately that
. Moreover, assume
first order conditions imply that
(A 6)
. Then managers'
. Substituting this into equation (A
5) gives:
.
However, then
if
. The same calculation shows that
contradicting the assumption that
(iii)
if
,
can be a solution, therefore
. Also, assumption 1(ii) ensures that
However, then
(A 7)
and hence
.
.
Managers' expected utility is:
(A 8)
which gives the value for r after observing that their outside option gives them utility
equal to zero and that the expression in brackets equals zero.
- 28 -
Proof of proposition 3:
Managers will accept any compensation offer
which satisfies
after
having chosen h. Since directors' compensation is decreasing in μ from assumption 5(i),
they will transfer
in every state in which they want to close and
in all other states. Since directors' pay increases in
, they will liquidate if and
only if:
(A 9)
which is the case if and only if s=L from assumption 3. Hence
for s=1,2 and
for s=L. Moreover, by the same reasoning as in proposition 2,
so that
managers' maximand becomes:
identically for all h. Hence,
if s=L. This makes
a function of h and
since D(h) cancels against
leaving the manager indifferent about h. Then
profits are:
(A 10)
which gives the same first order conditions as above and
is chosen.
Proof of proposition 4:
Setting
and rearranging gives:
(A 11)
which gives equation (11) in the text.
(ii) The profit-function for this case is:
- 29 (A 12)
and managers' utility:
(A 13)
Hence,
implies that managers choose
assumption 1(ii), therefore
. This cannot be true from
. Observe that
function of h from this with
can be written as a
>0. Hence:
(A 14)
which is negative for all
implies
managerial control, an
. Hence
and h is a continuous function of α s. t.
. Since at α=0 the director-mechanism dominates debt and pure
with the stated property must exist.
(iii) Assume α=1, i. e. the manager has all the bargaining-power. The manager's first
order conditions are the same as in the case of managerial control (cf. equation (A 6) in
the proof of proposition 2 above). Hence, owners choose the same h as in that case.
However,
which is larger than
, the transfer for the optimal
managerial contract by assumption 3. The same continuity argument as in section (ii)
applies to show the existence of an
with the required property.
- 30 Proof of proposition 5:
(i) It can never be optimal to liquidate when s=H, since xH>LH. Moreover, it cannot be
optimal to liquidate if s=M but not to liquidate if s=L since LL-xL>LM-xM from
assumption 3; this rules out l={M}. Also from assumption 3 it is not optimal not to
liquidate in state s=L since
is the maximum efficiency
loss from restructuring and smaller than the gain
. This leaves l={L} and
l={M,L} as the only possible candidates for an optimal restructuring-policy.
(ii) Consider l={L}, the policy implemented by the optimal managerial contract from
proposition 2. Then profits from pure managerial control are given by:
(A 15)
where μ(LL)=D(hE). Denote the optimal solution for the choice parameters under pure
managerial control by
and recall that they must satisfy:
(A 16)
from manager' participation and incentive compatibility constraints respectively. Under
debt-control, μ(LL)=0 since the manager does not have to be induced to close the
project. Then define:
(A 17)
and define the profit function under debt-control as:
(A 16)
- 31 Direct calculation shows that
maximized at
. However,
is generally not
and the maximized value will be greater. Hence, it is more
efficient to implement l={L} with debt-control rather than pure managerial control.
Moreover, if l={M,L} is the optimal policy, the ranking is
. The proof that
follows analogously to proposition 2.
Proof of proposition 7:
(i) The raider offers managers some payment b. By assumption, managers can always
stop a takeover. Hence, they will agree with the takeover if and only if
and the raider will pay D(h). From assumption 3, this will take place only if s=L and
the raider's profit from the takeover is
. If φ is large
enough, R>0 if q=0, hence in equilibrium 0<q<1. The condition for randomizing is
R=0 and can be solved to yield:
(A 19)
If φ is not large enough so that the expression in the text is negative, q=0. If a takeover
takes place, shareholders obtain:
(A 20)
where the fact that R=0 has been used for the last transformation. If there is no
takeover, initial shareholders simply receive xs. Hence, total expected profits are:
(A 21)
Hence, first order conditions are, using the definition of q above:
- 32 (A 22)
Comparing this with the first order conditions in proposition 1 gives that
are possible, depending on the sign of
, hence
if q=0.
at
or
. Finally, if q=0, then
- 33 Appendix B: Friendly Takeovers
This appendix extends the results of section 5.2 on takeovers. Suppose the corporate
charter could include a clause specifying that any severance pay received by the
manager in the event of a takeover is paid out of the company's cash flows and that
there is sufficient competition in the market for corporate control.
Proposition 8: Assume a successful bidder is permitted to grant managers severance
pay out of the target firm's funds and there are at least two potential bidders.
Moreover, if there are several bids, the highest bid must be accepted. Then the
first best is implemented choosing a takeover defense. The manager chooses
and obtains a payment
in the event of a takeover and takeovers take
place with probability 1.
Proof: The raider has to pay the manager at least D(h), otherwise the manager uses the
takeover defense. If this is offered, the post-takeover value of the firm is
, which is also the price the raider bids. The value of the company
without a takeover is xs, hence
.
Hence, the raider's profits are:
(A 23)
Hence, in equilibrium q=1 and R=0. Any bid offering more than
leads to negative profits, any bid lower than this invites competition.
Note that a similar result can be achieved with exclusion devices like restricted offers of
the kind discussed in Grossman/Hart (1980). The competition requirement is essential
and makes the result restrictive. If there was only one potential bidder, she could always
- 34 offer managers a bribe b>D(h) and shareholders a price
that a bid of
. Competition ensures
and a payment equal to the disutility is the unique equilibrium.
Hence, the market for corporate control can also implement the first-best solution if
three provisions are made:
-
managers are allowed to defend the company.
-
The bidder can overcome managers' resistance by offering them severance pay
if they abstain from using their rights. This is not the same as a golden
parachute which will normally be provided ex ante, i. e. before the event of a
takeover and has therefore very different incentive implications (cf. the
discussion in section 3 above).
-
Managers' separation payments D(h*) are taken out of the firm's funds and there
are at least two potential raiders.
Effectively, this implements the same kind of renegotiation-mechanism as discussed in
section 4 and hence much the same comments apply. Raiders take the place of
directors. They initiate the process and have all bargaining power. Managers exercise
veto-power with the potential use of takeover-defenses. The net benefits accrue to
initial shareholders because the bidder does not make a net profit in equilibrium.
Takeovers are friendly, because raiders have to buy managers' agreement to a bid. The
result shows that the takeover process can be understood as a mechanism which
renegotiates the managerial contract. However, unlike Scharfstein (1988) who uses a
similar notion, the key element of a takeover is the acquisition of control over the
company's assets, and it was shown (rather than assumed) how this leads to a change in
managers' compensation.
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