CORPORATIONS – Shareholders November 21, 2006

Optimal Contracts

• Optimal Size

• Corporate Governance

• Corporate Disclosure

• Insider Trading

• Insider Defences

Corporation – Sole Shareholder

• V

F

Vs E

Us

Fs

Slope = -1

Maximization of Owner’s Utility Firm Budget Constraint –

Determined By The Firm’s Profit Maximization Constraint

Corporation – Sole Shareholder

• Perfectly Competitive Firm • Monopoly Firm

SS = MC1

DP

a1

MC1 SATC SATC

PPC

PM

Corporation – Sole Shareholder

• Monopoly Firm

SS = MC1

DP

SATCPM

Optimal Contract Cost Curve (No moral hazard)

Optimal Profit

Surplus - No Agency Costs

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)

Inside Shareholder

(Agent 2)Outside Shareholder

(Agent 1)

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

SS = MC1

DP

SATCPM

Optimal Contract Cost Curve (No moral hazard)

Optimal Joint Social Surplus With Agency Costs

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 2 (Insider)

S

DP

a2

PM

• Agent 1 (Outsider)

S

a1

Optimal Contract Cost Curve

Optimal Joint Social Surplus

Surplus With Agency Costs

Corporation – Shareholders

V

F

Vs E

E* Us

Fs

Firm Budget Constraint – Determined By Insider’s Profit which is partially “subsidized” by the outsiders

Maximization of Insider’s Utility

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 2

S

DP

a2

PM

• Agent 1

S

a1

CMC

Maximum Joint Social Surplus

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

F

Vs E

Us

Equity Expansion Path

Fs

Point where corporation becomes too big for owner and owner can start buying additional needs on the open market

EBoundary

Slope = -1

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

F

Vs E

E*

Point where corporation becomes too big for owner and owner can start buying additional needs on the open marketEBoundary

Slope = -1

Slope = -

Corporation – Optimal Size Of Firm

V

F

Agency cost of having outside shareholders E*

Point where corporation becomes too big for owner and owner can start buying additional needs on the open marketEBoundary

Slope = -1

Slope = -

Corporation – Optimal Size Of Firm

V

F

Agency costs = A

E*

Expansion Path of Firm at agency costs = 0

Expansion Path of Firm at agency costs = A

Slope = -1

Slope = -

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 GovernanceV

F

Agency costs = A

E*

Expansion Path of Firm at agency costs = 0

Expansion Path of Firm at agency costs = A

Slope = -1

Slope = -

Corporate GovernanceV

F

Expansion Path of Firm at agency costs = 0

Optimal Monitoring Costs = MOptimal Level of Agency Costs With MonitoringExpansion Path of Firm at agency costs = A

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-)/ = M

C represents the joint investment function of the shareholders

Corporate GovernanceV

F

Agency costs = A

E*

Expansion Path of Firm at agency costs = 0

Expansion path with optimal governanceExpansion Path of Firm at agency costs = A

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

F

Firm Expansion – Insider Trading Restricted

Utility Curve of Insider – Insider Trading Restricted Utility Curve of Insider – Insider Trading Unrestricted

Slope = -1

Slope = -

Slope = -

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