Aswath Damodaran 0

CORPORATE GOVERNANCE:
DEFINING THE END GAME
“If I have to choose between you and me - I like
me better.”
 First Principles
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Maximize the value of the business (firm)

The Investment Decision The Financing Decision The Dividend Decision

Invest in assets that earn a Find the right kind of debt If you cannot find investments
return greater than the for your firm and the right that make your minimum
minimum acceptable hurdle mix of debt and equity to acceptable rate, return the cash
rate fund your operations to owners of your business

The hurdle rate The return How much How you choose
should reflect the The optimal The right kind
should reflect the cash you can to return cash to
riskiness of the mix of debt of debt
magnitude and return the owners will
investment and and equity matches the
the timing of the depends upon depend on
the mix of debt maximizes firm tenor of your
cashflows as well current & whether they
and equity used value assets
as all side effects. potential prefer dividends
to fund it. investment or buybacks
opportunities

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 The Objective in Decision Making
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¨ In traditional corporate finance, the objective in decision making is to

maximize the value of the firm.
¨ A narrower objective is to maximize stockholder wealth. When the stock
is traded and markets are viewed to be efficient, the objective is to
maximize the stock price.
Maximize equity Maximize market
Maximize value estimate of equity
firm value
value
Assets Liabilities
Existing Investments Fixed Claim on cash flows
Generate cashflows today Assets in Place Debt Little or No role in management
Includes long lived (fixed) and Fixed Maturity
short-lived(working Tax Deductible
capital) assets

Expected Value that will be Growth Assets Equity Residual Claim on cash flows
created by future investments Significant Role in management
Perpetual Lives
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 Maximizing Stock Prices is too narrow an
objective: A preliminary response
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¨ Maximizing stock price is not incompatible with

meeting employee needs/objectives. In particular:
¤ Employees are often stockholders in many firms
¤ Firms that maximize stock price generally are profitable
firms that can afford to treat employees well.
¨ Maximizing stock price does not mean that
customers are not critical to success. In most
businesses, keeping customers happy is the route to
stock price maximization.
¨ Maximizing stock price does not imply that a
company has to be a social outlaw.
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 The Classical Objective Function
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STOCKHOLDERS

Hire & fire Maximize

managers stockholder
- Board wealth
- Annual Meeting

Lend Money No Social Costs

BONDHOLDERS/ Managers SOCIETY
LENDERS Protect All costs can be
bondholder traced to firm
Interests
Reveal Markets are
information efficient and
honestly and assess effect on
on time value

FINANCIAL MARKETS

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 What can go wrong?
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STOCKHOLDERS

Have little control Managers put

over managers their interests
above stockholders

Lend Money Significant Social Costs

BONDHOLDERS Managers SOCIETY
Bondholders can Some costs cannot be
get ripped off traced to firm
Delay bad
news or Markets make
provide mistakes and
misleading can over react
information

FINANCIAL MARKETS

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 The Annual Meeting as a disciplinary venue
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¨ The power of stockholders to act at annual meetings is

diluted by three factors
¤ Most small stockholders do not go to meetings because the cost
of going to the meeting exceeds the value of their holdings.
¤ Incumbent management starts off with a clear advantage when
it comes to the exercise of proxies. Proxies that are not voted
becomes votes for incumbent management.
¤ For large stockholders, the path of least resistance, when
confronted by managers that they do not like, is to vote with
their feet.
¨ Annual meetings are also tightly scripted and controlled
events, making it difficult for outsiders and rebels to
bring up issues that are not to the management’s liking.

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 And institutional investors go along with incumbent
managers…
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 Board of Directors as a disciplinary mechanism
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¨ Directors are paid well: In 2010, the median board member at a Fortune
500 company was paid $212,512, with 54% coming in stock and the
remaining 46% in cash. If a board member was a non-executive chair, he
or she received about $150,000 more in compensation.
¨ Spend more time on their directorial duties than they used to: A board
member worked, on average, about 227.5 hours a year (and that is being
generous), or 4.4 hours a week, according to the National Associate of
Corporate Directors. Of this, about 24 hours a year are for board
meetings. Those numbers are up from what they were a decade ago.
¨ Even those hours are not very productive: While the time spent on being
a director has gone up, a significant portion of that time was spent on
making sure that they are legally protected (regulations & lawsuits).
¨ And they have many loyalties: Many directors serve on three or more
boards, and some are full time chief executives of other companies.

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 The CEO often hand-picks directors..
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¨ CEOs pick directors: A 1992 survey by Korn/Ferry revealed that 74% of

companies relied on recommendations from the CEO to come up with
new directors and only 16% used an outside search firm. While that
number has changed in recent years, CEOs still determine who sits on
their boards. While more companies have outsiders involved in picking
directors now, CEOs exercise significant influence over the process.
¨ Directors don’t have big equity stakes: Directors often hold only token
stakes in their companies. Most directors in companies today still receive
more compensation as directors than they gain from their stockholdings.
While share ownership is up among directors today, they usually get these
shares from the firm (rather than buy them).
¨ And some directors are CEOs of other firms: Many directors are
themselves CEOs of other firms. Worse still, there are cases where CEOs
sit on each other s boards.

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 Directors lack the expertise (and the willingness)
to ask the necessary tough questions..
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¨ Robert’s Rules of Order? In most boards, the CEO

continues to be the chair. Not surprisingly, the CEO sets
the agenda, chairs the meeting and controls the
information provided to directors.
¨ Be a team player? The search for consensus overwhelms
any attempts at confrontation.
¨ The CEO as authority figure: Studies of social psychology
have noted that loyalty is hardwired into human
behavior. While this loyalty is an important tool in
building up organizations, it can also lead people to
suppress internal ethical standards if they conflict with
loyalty to an authority figure. In a board meeting, the
CEO generally becomes the authority figure.
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 The worst board ever? The Disney Experience -
1997
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 Application Test: Who s on board?
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¨ Look at the board of directors for your firm.

¤ How many of the directors are inside directors (Employees of the firm,
ex-managers)?
¤ Is there any information on how independent the directors in the firm
are from the managers?
¨ Are there any external measures of the quality of corporate
governance of your firm?
¤ Yahoo! Finance now reports on a corporate governance score for firms,
where it ranks firms against the rest of the market and against their
sectors.
¨ Is there tangible evidence that your board acts independently
of management?
¤ Check news stories to see if there are actions that the CEO has wanted
to take that the board has stopped him or her from taking or at least
slowed him or her down.
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 So, what next? When the cat is idle, the mice
will play ....
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¨ When managers do not fear stockholders, they will often put

their interests over stockholder interests
No stockholder approval needed….. Stockholder Approval needed

¤ Greenmail: The (managers of ) target of a hostile takeover buy out the

potential acquirer's existing stake, at a price much greater than the
price paid by the raider, in return for the signing of a 'standstill'
agreement.
¤ Golden Parachutes: Provisions in employment contracts, that allows
for the payment of a lump-sum or cash flows over a period, if
managers covered by these contracts lose their jobs in a takeover.
¤ Poison Pills: A security, the rights or cashflows on which are triggered
by an outside event, generally a hostile takeover, is called a poison pill.
¤ Shark Repellents: Anti-takeover amendments are also aimed at
dissuading hostile takeovers, but differ on one very important count.
They require the assent of stockholders to be instituted.
¤ Overpaying on takeovers: Acquisitions often are driven by
management interests rather than stockholder interests.
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 Application Test: Who owns/runs your firm?
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¨ Look at the top shareholders in your firm.

¤ Who are the top stockholders in your firm?
¤ What are the potential conflicts of interests that you see emerging
from this stockholding structure?
¨ Make your judgment on where the power lies.
Government
Outside stockholders Managers
- Size of holding - Length of tenure
- Active or Passive? - Links to insiders
- Short or Long term? Control of the firm

Employees Lenders

Inside stockholders
% of stock held
Voting and non-voting shares
Control structure
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 Source for data: Will vary across Percent of outstanding
markets. 13F is SEC filing for US shares in company
mutual/pension funds

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 Corporate Governance: Assessing where the
power lies and potential conflicts of interest
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 1. Institutional Default
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 2. Self Holdings?
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 3. The Government Influence?
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 4. Different voting rights?
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 5. Family Group Companies
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 6. Founders hang on…
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 7. Corporate Cross Holdings
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 8. Activist investors
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 So this is what can go wrong...
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STOCKHOLDERS

Managers put
Have little control their interests
over managers above stockholders

Lend Money Significant Social Costs

BONDHOLDERS Managers SOCIETY
Bondholders can Some costs cannot be
get ripped off traced to firm
Delay bad
news or Markets make
provide mistakes and
misleading can over react
information

FINANCIAL MARKETS

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 Traditional corporate financial theory breaks
down when ...
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¨ Managerial self-interest: The interests/objectives of the

decision makers in the firm conflict with the interests of
stockholders.
¨ Unprotected debt holders: Bondholders (Lenders) are
not protected against expropriation by stockholders.
¨ Inefficient markets: Financial markets do not operate
efficiently, and stock prices do not reflect the underlying
value of the firm.
¨ Large social side costs: Significant social costs can be
created as a by-product of stock price maximization.

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 When traditional corporate financial theory
breaks down, the solution is:
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¨ A non-stockholder based governance system: To choose a

different mechanism for corporate governance, i.e, assign the
responsibility for monitoring managers to someone other
than stockholders.
¨ A better objective than maximizing stock prices? To choose a
different objective for the firm.
¨ Maximize stock prices but minimize side costs: To maximize
stock price, but reduce the potential for conflict and
breakdown:
¤ Making managers (decision makers) and employees into stockholders
¤ Protect lenders from expropriation
¤ By providing information honestly and promptly to financial markets
¤ Minimize social costs

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 I. An Alternative Corporate Governance System
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¨ Germany and Japan developed a different mechanism for

corporate governance, based upon corporate cross holdings.
¤ In Germany, the banks form the core of this system.
¤ In Japan, it is the keiretsus
¤ Other Asian countries have modeled their system after Japan, with family
companies forming the core of the new corporate families
¨ At their best, the most efficient firms in the group work at bringing
the less efficient firms up to par. They provide a corporate welfare
system that makes for a more stable corporate structure
¨ At their worst, the least efficient and poorly run firms in the group
pull down the most efficient and best run firms down. The nature
of the cross holdings makes its very difficult for outsiders (including
investors in these firms) to figure out how well or badly the group
is doing.

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 II. Choose a Different Objective Function
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¨ Firms can always focus on a different objective function.

Examples would include
¤ maximizing earnings
¤ maximizing revenues
¤ maximizing firm size
¤ maximizing market share
¤ maximizing EVA
¨ The key thing to remember is that these are
intermediate objective functions.
¤ To the degree that they are correlated with the long term health
and value of the company, they work well.
¤ To the degree that they do not, the firm can end up with a
disaster

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 III. Maximize Stock Price, subject to ..
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¨ The strength of the stock price maximization objective

function is its internal self correction mechanism. Excesses on
any of the linkages lead, if unregulated, to counter actions
which reduce or eliminate these excesses
¨ In the context of our discussion,
¤ managers taking advantage of stockholders has led to a much more
active market for corporate control.
¤ stockholders taking advantage of bondholders has led to bondholders
protecting themselves at the time of the issue.
¤ firms revealing incorrect or delayed information to markets has led to
markets becoming more skeptical and punitive
¤ firms creating social costs has led to more regulations, as well as
investor and customer backlashes.

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 The Counter Reaction
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STOCKHOLDERS

1. More activist Managers of poorly

investors run firms are put
2. Hostile takeovers on notice.

Protect themselves Corporate Good Citizen Constraints

BONDHOLDERS Managers SOCIETY
1. Covenants 1. More laws
2. New Types 2. Investor/Customer Backlash
Firms are
punished Investors and
for misleading analysts become
markets more skeptical

FINANCIAL MARKETS

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 Eisner s exit… and a new age dawns? Disney s board
in 2008
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Disney: Eisner’s rise & fall from grace

¨ In his early years at Disney, Michael Eisner brought about long-delayed changes in
the company and put it on the path to being an entertainment giant that it is
today. His success allowed him to consolidate power and the boards that he
created were increasingly captive ones (see the 1997 board).
¨ In 1996, Eisner spearheaded the push to buy ABC and the board rubberstamped
his decision, as they had with other major decisions. In the years following, the
company ran into problems both on its ABC acquisition and on its other
operations and stockholders started to get restive, especially as the stock price
halved between 1998 and 2002.
¨ In 2003, Roy Disney and Stanley Gold resigned from the Disney board, arguing
against Eisner’s autocratic style.
¨ In early 2004, Comcast made a hostile bid for Disney and later in the year, 43% of
Disney shareholders withheld their votes for Eisner’s reelection to the board of
directors. Following that vote, the board of directors at Disney voted unanimously
to elect George Mitchell as the Chair of the board, replacing Eisner, who vowed to
stay on as CEO.

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But as a CEO’s tenure lengthens, does
corporate governance suffer?
1. In 2011, Iger announced his intent to step down as CEO in 2015
to allow a successor to be groomed.
2. The board voted reinstate Iger as chair of the board in 2011,
reversing a decision made to separate the CEO and Chair
positions after the Eisner years.
3. There were signs of restiveness among Disney’s stockholders,
especially those interested in corporate governance. Activist
investors (CalSTRS) starting making noise and Institutional
Shareholder Services (ISS), which gauges corporate governance at
companies, raised red flags about compensation and board
monitoring at Disney.

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 Iger’s non-exit and the Domino effect
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1. In 2015 but Disney’s board convinced Iger to stay

on as CEO for an extra year, for the “the good of
the company”.
2. In 2016, Thomas Staggs who was considered heir
apparent to Iger left Disney. Others who were
considered potential CEOs also left.
3. In 2017, Disney acquired Fox and announced that
Iger’s term would be extended to 2019 (and
perhaps beyond) because his stewardship was
essential for the merger to work.
¤ Now, what?

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 Do we need good corporate governance?
Managers do a good job, don’t they?
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 Is there a payoff to better corporate
governance?
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¨ In the most comprehensive study of the effect of corporate governance

on value, a governance index was created for each of 1500 firms based
upon 24 distinct corporate governance provisions.
¤ Buying stocks that had the strongest investor protections while simultaneously
selling shares with the weakest protections generated an annual excess return of
8.5%.
¤ Every one point increase in the index towards fewer investor protections decreased
market value by 8.9% in 1999
¤ Firms that scored high in investor protections also had higher profits, higher sales
growth and made fewer acquisitions.
¨ The link between the composition of the board of directors and firm value
is weak. Smaller boards do tend to be more effective.
¨ On a purely anecdotal basis, a common theme at problem companies and
is an ineffective board that fails to ask tough questions of an imperial CEO.

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 Should we legislate it?
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¨ Every corporate scandal creates impetus for a

legislative response. The scandals at Enron and
WorldCom laid the groundwork for Sarbanes-Oxley.
¨ You cannot legislate good corporate governance.
¤ The costs of meeting legal requirements often exceed the
benefits
¤ Laws always have unintended consequences

¤ In general, laws tend to be blunderbusses that penalize

good companies more than they punish the bad
companies.

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