Corporate Governance

The firm is a nexus of contracts, and the corporation is a firm whose equity claims have limited liability and are generally traded on liquid markets. Corporate governance refers to the rules, procedures, and administration of the firm’s contracts with its shareholders, creditors, employees, suppliers, customers, and sovereign governments. Governance is legally vested in a board of directors who have a fiduciary duty to serve the interests of the corporation rather than their own interests or those of the firm’s management (see Clark, 1985).

The apparent simplicity of this description disguises two key problems which have stimulated most popular and academic interest in corporate governance:

  1. First, what exactly is meant by the interests of the corporation, given that corporation is not an individual?
  2. Second, the courts’ ability to enforce the vague notion of fiduciary duty is limited at best (Romano, 1991). What other forces exist to motivate self-interested directors and managers to serve corporate interests?


One way in which financial economists have answered both questions is to maintain that corporate interests are identical to the wealth of shareholders, and that directors and managers are motivated to serve these interests by incentive pay, by their own shareholdings and reputational concerns, and by the threat of takeover. This approach must, however, be supplemented by the recognition that in some firms the costs and benefits of corporate decisions are also borne by parties such as creditors and long-term employees. We conclude that the most promising areas for further research are based on the recognition that the optimal governance structure varies widely across corporations, depending on the relative importance of these various claims on its cash flows; see Garvey and Swan (1994) for a more extensive survey.


Governance and Performance

The question of most immediate relevance to researchers and commentators is how governance affects firm performance and, in particular, whether firms perform better when shareholders’ interests are likely to be dominant. Such firms are identified in the empirical literature either by the proportion of outsiders who serve on the board of directors, or by the linkage between chief executive officer (CEO) wealth and the wealth of shareholders.

Evidence on the role of outside board members is provided by Rosenstein and Wyatt (1990) who find that the appointment of outsiders to the board is associated with a stock price increase and by Weisbach (1988) who finds that outsider-dominated boards are more likely to dismiss the CEO for poor share price performance. Evidence on the performance effects of CEO incentives can be found in DeFusco et al. (1990), who document an increase in the share price of firms which introduce stock option or ownership plans, and in McConnell and Servaes (1990) who find a positive relationship between the percentages of shares owned by managers and board members and firms’ market-to-book values.

This type of evidence is not as useful as it might appear. In particular, it does not establish that firms should increase outside board membership or CEO incentive pay as advocated by the American Law Institute (1982). First, an increase in the stock price could be driven by wealth transfers rather than efficiency gains. Indeed, DeFusco et al. (1990) found that the increase in share price was also associated with a decline in the value of the firm’s outstanding debt. Second, even if the share price were a reliable guide to performance, compensation and board structures are not chosen randomly as required by the performance studies. A recent study by Agrawal and Knoeber (1994) attempts to account for the endogeneity of compensation and board structure, and comes to the provocative conclusion that many firms have too many rather than too few outside members on their boards. To disentangle these effects, we need to understand more about the effects of various governance mechanisms and how they relate to a firm’s unique environment and strategies.


Governance and Behavior

A less obvious but arguably more useful research strategy is to examine how different governance mechanisms affect the firm’s behavior rather than its performance. While this approach cannot tell us whether actions such as the dismissal of a CEO or rejection of a takeover bid is optimal for the firm in question, it is an essential input into any understanding of optimal governance structures.

The most robust finding is that changes in control due to takeover or insolvency bring dramatic changes in firm personnel and strategy. Gilson and Vetsuypens (1993) document that CEO and board member turnover increases radically in the event the firm goes into financial distress. Martin and McConnell (1991) present similar findings for a hostile takeover. These findings suggest if nothing else that incumbent managers and board members will take steps to avoid takeover or insolvency, either by increasing the firm’s cash flows or by some less productive avenue.

The importance of the takeover threat depends not only on the slack to be found in the target firm, but also on the premium that must be paid by a bidder. Grossman and Hart (1980) show that collective choice problems between target shareholders can greatly increase this premium, thereby deterring many takeovers. Stulz et al. (1990) find evidence that the severity of this problem differs across firms, and is mitigated when a firm’s shares are concentrated in the hands of financial institutions. Brickley et al.’s (1994) study of voting on anti-takeover amendments provides further evidence of the rich differences that exist between firms. They find that only those institutional shareholders who have no obvious business ties to the firm are willing to oppose management-sponsored anti-takeover amendments. Such heterogeneity leads naturally to our final question; how are these differences adapted to the different environments of firms?


Governance Structures and Environments

Governance mechanisms are not cost free. Any party who would oversee management must bear the direct costs of monitoring and the indirect costs of bearing firm risk. Demsetz and Lehn (1985) were the first to explicitly recognize these costs and ask how governance characteristics vary with the attributes of each firm’s environment. They found that shareholdings were less concentrated in larger firms, in regulated firms, and in firms whose profits were more predictable. Garen (1994) finds that such firms also tend to exhibit less incentive pay for the CEO, because the benefits of oversight and incentive-alignment are smaller relative to their costs for such firms.

The ambiguous results of the performance studies summarized above suggest that corporate performance cannot be reliably increased simply by adding outsiders to the board of directors or by increasing the CEO’s stock-holdings. Future research efforts are better devoted to understanding why and how governance structures differ across firms. Studies such as Kaplan (1994) provide useful evidence on how Japanese and German firms differ from their US counterparts. Other differences that merit further study include the liquidity of the stock market (e.g. Bhide, 1993) and the importance of employee claims on the firm’s future cash flows (see Garvey and Swan, 1992).


Resources for Corporate Governance:

Agrawal, A. & Knoeber, C. R. (1994). Firm performance and control mechanisms to control agency problems between managers and shareholders. Working Paper, The Wharton School, University of Pennsylvania.

American Law Institute (1982). Principles of corporate governance and structure: Restatement and recommendations. 1st edn, Philadelphia, PA: American Law Institute. Bhide, A. (1993). The hidden costs of stock market liquidity. Journal of Financial Economics, 34, 31–51.

Brickley, J. Lease, R. & Smith, C. W (1994). Corporate voting: evidence from charteramendment proposals. Journal of Corporate Finance, 1, 5–32.

DeFusco, R., Johnson, R. & Zorn, T. (1990). The effect of executive stock option plans on stockholders and bondholders. Journal of Finance, 45, 617–27.

Demsetz, H. & Lehn, K. (1985). The structure of corporate ownership: causes and consequences. Journal of Political Economy, 93, 1155–77.

Garen, J. (1994). Executive compensation and principal-agent theory. Journal of Political Economy, 102, 1175–99.

Garvey, G. T. & Swan, P. L. (1992). Optimal capital structure for a hierarchical firm. Journal of Financial Intermediation, 2, 376–400.

Garvey, G. T. & Swan, P. L. (1994). The economics of corporate governance: beyond the Marshallian firm. Journal of Corporate Finance, 1, 139–74.

Gilson, S. C. & Vetsuypens, M. R. (1993). CEO compensation in financially distressed firms: an empirical analysis. Journal of Finance, 48, 425–58.

Grossman, S. & Hart, O. D. (1980). Takeover bids, the free rider problem, and the theory of the corporation. Bell Journal of Economics, 11, 42–64.

Jensen, M. C. (1986). Agency costs of free cash flow, corporate finance and takeovers. American Economic Review, 76, 323–29.

Kaplan, S. (1994). Top executive rewards and firm performance: a comparison of Japan and the United States. Journal of Political Economy, 102, 510–46.

Martin, K. & McConnell, J. (1991). Corporate performance, corporate takeovers and management turnover. Journal of Finance, 46, 671–87.

McConnell, J. J. & Servaes, H. (1990). Additional evidence on equity ownership and corporate value. Journal of Financial Economics, 27, 595–612.

Romano, R. (1991). The shareholder suit: litigation without foundation? Journal of Law, Economics, and Organization, 7, 55–88.

Rosenstein, S. & Wyatt, J. G. (1990). Outside directors, board independence, and shareholder wealth. Journal of Financial Economics, 27, 175–91.

Stulz, R., Walkling, R. & Song, M. H. (1990). The distribution of target ownership and the division of gains in successful takeovers. Journal of Finance, 45, 817–34.


Corporate Takeover Language

The word “takeover” is used as a generic term to refer to any acquisition through a tender
offer. In layman’s language it is a straightforward transaction in which two firms decide to combine their assets either in a friendly or unfriendly manner under established legal

A “friendly takeover” is sometimes referred to as a merger or synergistic takeover; it occurs when an acquiring firm referred to as bidder or raider and target firm agree to combine their businesses to realize the benefits. Synergistic gains can accrue to the corporation from consolidation of research and development labs or of market networks.
Merger proposals require the approval of the managers (board of directors) of the target corporation. “Hostile takeovers” are also called disciplinary takeovers in the literature. The purpose of such takeovers seems to be to correct the non-value-maximizing practices of managers of the target corporations. Takeover proposals do not need the approval of the managers of the target corporation. In fact, they are made directly to the shareholders of the target.

A “tender offer” is an offer by bidder or raider directly to shareholders to buy some or all of their shares for a specified price during a specified time. Unlike merger proposals, any tender offers for takeovers are made and successfully executed over the expressed objections of the target management.

Prior to 1960s, the so-called “intra-firm tender offer” was used exclusively to acquire shares in the issuer’s repurchase program. The separation of ownership and control in large corporations led to the development of the “inter-firm tender offer” as an important vehicle and became a popular mechanism for transfer of ownership.

An “any-or-all-tender offer” is where the bidder or raider will buy any tendered shares of the target corporation as long as the conditions of minimum number of tendered shares are met to insure majority control after the offer.

In a “conditional tender offer” the raider specifies a maximum number of shares to be purchased in addition to the minimum required. If the bid is oversubscribed, the tendered share becomes subject to pro-rationing. This tender offer is further subdivided into two-tier negotiated, non-negotiated, and partial tender offers.

A “two-tier tender offer” is a takeover offer that provides a cash and non-cash price in two steps. In the first step, there is a cash price offer for sufficient shares to obtain control of the corporation, then in the second step, a lower non-cash (securities) price is offered for the remaining shares.

A “pure partial tender offer” is defined as one in which there is no announced second-tier offer during the tender offer and no clean-up merger or tender offer closely following the execution of the tender offer. Partial offers are commonly used for less than 50 percent control of ownership in the corporation.

In a “negotiated two-tier tender offer” the bidder or raider, at the time of the first-tier offer agrees with target management on the terms of the subsequent merger. By contrast, in a “non-negotiated two-tier tender offer” no terms are agreed to at the time of the original offer for control of corporation. This lies between the pure partial offer and non-negotiated two-tier tender offer.

The “raider or bidder” is the person(s) or corporation who identifies the potential target and attempts to take over. “Target” is the potential corporation at which the takeover attempt is directed. If the number of shares tendered in a takeover bid are more than required by their conditional offer (i.e. if the bid is oversubscribed) then the raider will buy the same proportion of shares from everyone who tendered; this is known as “pro-rationing”.

The “dilution factor” is the extent to which the value of minority shareholders is diluted after the takeover of a corporation. It is prohibited by the Securities and Exchange Commission.

But it is argued that it is necessary to create a divergence between the value of the target corporation to its shareholders and the value to the raider or the bidder to overcome the free-rider problem.

The “crown jewel” is the most valued asset held by an acquisition target, and divestiture of this asset is frequently a sufficient defense to discourage takeover of the corporation.

A “fair price-amendment” requires supermajority approval of non-uniform, or two-tier, tender offers. Takeover bids not approved by the board of directors can be avoided by a uniform bid for less than all outstanding shares (if the bid is oversubscribed, it is subjected to pro-rationing).

Golden parachutes” are provisions in the employment contracts of top-level executives that provide for severance pay or other compensation should they lose their job as a result of a hostile takeover.

Greenmail” is the premium paid by a targeted company to a raider or bidder in exchange for his acquired shares of the targeted company.

Leveraged buyout” is the purchase of publicly owned company stock by the incumbent management with a portion of the purchase price financed by outside investors. The company is delisted and public trading in the stock ceases.

A “lockup defense” gives a friendly party (i.e. white knight) the right to purchase assets of the corporation, in particular the crown jewel, thus discouraging a takeover attempt by the raider.

The term “maiden” is sometimes used to refer to the company at which the takeover is directed by the raider or bidder (i.e. target).

A “poison pill” is used as a takeover defense by the incumbent management; it gives stockholders other than those involved in a hostile takeover the right to purchase securities at a very favorable price in the event of a takeover bid.

A “proxy contest” involves the solicitation of stockholder votes generally for the purpose of electing a slate of directors in competition with the current directors to change the composition.

Shark repellant” is an anti-takeover corporate charter amendment such as staggered terms for directors, supermajority requirement for approving merger, or mandate that bidders pay the same price for all shares in a buyout. A “standstill agreement” is a contract in which a raider or corporation agrees to limit its holdings in the target corporation and not make a takeover attempt.

A successful raider who, once the target is acquired, sells off some of the assets of the target company to destroy its original entity, is known as a “stripper“.

A “targeted repurchase” is a repurchase of common stock from an individual holder or a tender repurchase that excludes an individual holder. The former is the most frequent form of greenmail, while the latter is a common defensive tactic against takeover.
A “white knight” is a merger partner solicited by management of a target corporation who offers an alternative merger plan to that offered by the raider which protects the target company from the takeover.

A “kick in the pants” is new information that induces the incumbent management to implement a higher-valued strategy on its own.

Sitting on the gold mine” is where the dissemination of the new information prompts the market to revalue previously “undervalued” target shares.

In a “management buyout” a management team within a corporation or division purchases that corporation from its current owners, thus becoming owner managers. It is prevalent in both the private and public sectors and is one means by which privatization may take place.