MSc IB&M, Semester 2 2010-2011
Master Thesis:
Management Actions and Corporate Governance
An Analysis from an Agency Theory and Applied Finance Point of View
Page 1 Abstract
Page 3 Table of Contents
Chapter 1: Introduction……….4
Chapter 2: Theoretical Framework……….………..8
1) Ownership/Shareholders……….8
2) Executive Management……….11
3) Board of Directors……….12
4) Creditors………13
Chapter 3: The Traditional View On Corporate Governance……….16
1) Contracting………18
a) Optimal Contracting Approach………...18
b) Managerial Power Approach………...22
c) Contingencies………..24
2) Board of Director and Other Monitoring Entities……….24
a) Internal Monitoring……….25
b) External Monitoring………27
Chapter 4: The Modern View On Corporate Governance………..31
1) Risk, Control & Cashflows………...32
2) Leverage & Limited Liability………...35
3) Strategies for the Exploitation of the Creditors………36
a) High Leverage……….….…………37
b) Structural Organizational Change……….………..37
- Layered Levered Organization……….37
- Hub Levered Organization……….………..…39
- Pyramid Structure Organization……….…………..39
c) Restricted Voting Share Structures……….………41
d) Creditor Characteristics Manipulation………...41
e) Moral Hazard………..……….42
Chapter 5: The Social Psychological View……….46
Chapter 6: Results & Discussion………...50
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Chapter 1: Introduction
The 2007 and 2009 financial crisis has had a major impact on the world. To this day, in 2011, governments in collaboration with banks and financial institutions are trying to tidy
governmental balance sheets to create a healthier global financial system. The newspapers are full of news about the debt crisis in Greece, Ireland and Portugal and how their fellow
members of the EU, EMU and IMF are attempting to restructure their government budgets.
The question is how did it get so far, that the entire global economic system was damaged so much that it still is on recovery. Global economics are made up of smaller country economics and these can be further dissected into the combination of company performances, though additional country specific elements like savings, taxes, interest and inflation rates have an influence on the traditional Keynesian model as well. Nevertheless this paper considers the corporate side of economics in general, since the impact of these organizations on
macroeconomics has become detrimental. Multinational organizations have increased by size in terms of employee counts, profits and operations, but also by the number of countries they operate in. Consequentially these multinationals are a topic of discussion in many academic fields.
Page 5 most favorable financial climate, as though they were window shopping on an international scale, in the effort to obtain as high a profit margin as possible.
Many have considered their desire for these profit margins to be at the expense of the general financial stability and the economic system in the long run (Laeven, 2009, Wymeersch, 2008, Heremans, 2007, Bebchuk & Spamann 2009, Allen & Carletti, 2008). As a single observation this has been true, since the practices engaged in by banks and financial institutions were at least one of the triggers of and probably a major contributor to the financial crisis (Hua & Thum, 2009).
So these financial entities have a major influence on global economics with many different stakeholders involved. It therefore seems not less than appropriate that these organizations are controlled or regulated to such an extent that the chance of events taking a turn for the worse are minimized. However, within this system of controlling and regulating there seems to be some discrepancy between what appears right for the global economics and what the owners of the organizations desire. Governments are interested in keeping the economic cycles as smooth as possible, with a bandwidth as small as possible between downturns and uprisings. So their part is in stabilizing the sector by regulating it (Laeven & Levine, 2009, Becher & Frye, 2011, Bruno & Claessens, 2010).
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interest of these owners and therefore the guidelines as well, are different from the ones the government imposes in the sense that financial sectorial stability requires reserves and stationary money (Allen & Gale, 1997, Allen & Carletti, 2008, Allen & Chui, 2008,
Wymeersch, 2008). This inertly compromises the profit-making principle of company owners because idle money does not make money (Allen & Carletti, 2008, Allen, Chui & Maddaloni, 2008, Heeremans, 2010, Wymeersch, 2008).
So the reason why Corporate Governance came into existence is to make sure that the interest of shareholders, which is to receive as much return on their investment as possible, is aligned with the interests of management, which are to be properly compensated for their imposed risk (John, Litov & Yueng, 2008) and specialization (Klein, 1983, Demsetz, 1997) on how to run an organization. The general consensus till the 1990‟s in Corporate Governance literature is that managers want to expropriate rents from the company through their ability to steer the organization. From the 1990‟s up until the present we find a shift in the literature towards an alternative view. This Modern View states that management is aligned with shareholders through various mechanisms, and that management and shareholders together are taking opportunities to create high returns at the expense of creditors or small shareholders. The research question of this paper is: “How Does Corporate Governance Influence
Managements’ Actions?”. What this paper investigates is what the influence of the
Page 7 Modern View, states that management and shareholders together engage in highly risky investments because they are able to manipulate risk, control and cashflow rights of the organization. The third view, called the Social Psychological View, complements the modern view in the sense that it explains why managers take risky actions from sociologist point of view.
This thesis proposes two answers to the research question. Chapter 2 will introduce the 4 most important stakeholders in an organization. They will be analyzed according to the Agency Theory, which is throughout the thesis the framework which ties the four stakeholders together. Chapter 3 than treats the first perspective on the dependent variable of Corporate Governance, which I will call the Traditional View on corporate governance, where management has the incentive to become wealthier at the expense of the survival of the organization and will therefore manipulate the performance of a particular organization. Chapter 4 will look at the alternative view on the dependent variable, which I will call the Modern View on corporate governance. To supplement to the Modern View, Chapter 5
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Chapter 2: Theoretical Framework
The research question of this paper is how corporate governance influences managements‟ actions. It will analyze two distinct threads of literature and will eventually differentiate two alternative answers to the question of how corporate governance influences management. This chapter contains an introduction to the theory that provides the framework or backbone for the arguments in this paper, that of principal-agency theory. Additionally it will provide some background information on the 4 stakeholders this paper analyses (Mülbert, 2009) and what their motivations and incentives are.
1) Ownership/shareholders
Every organization has some form of ownership. This ownership can be concentrated into one person or one other organization or it could be dispersed amongst many people and
organizations over various countries. Both forms of ownership have advantages and disadvantages to them. On the one hand of the spectrum is the individual or singular ownership form. This means, that even in the case of the existence of shares within a
company, just one person is the owner of the company since he holds all of them. The specific advantages of this ownership form are that he has all the control or voting rights in his
Page 9 an investment and interest rates are high, he is either forced to accept the high interest on loans or the owner has to reinvest profits otherwise desired elsewhere. Even individual owners are looking for return on their initial investment or for compensation for the risk they engaged in, in the form of profits. Therefore, forced reinvestment can be very harmful for a single owner.
The second downside of single person ownership is the none-existence of risk diversification. In cases of economic downturn, the owner is forced to endure the hardship of the company himself if he wishes to have the organization survive. If the owner lacks the liquidity to capitalize the company, the company goes bankrupt (White, 1983, Bris et. all, 2006, Citron & Wright, 2008) which means he losses thee deadweight or sunk costs of the firm (White, 1983). In other words, the owner is exposed to systemic risk of the economy all by himself.
The third disadvantage is linked to the second one, in that the owner is also the bearer of company specific risk. If the knowledge of the owner or of his advisors turns out to be
unsatisfactory, the endeavors of the company can turn out to be unprofitable, investments can be made in the wrong places and can fail to produce returns. The consequences of such faulty operations are all on the individual owner.
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of dispersion of control and cashflow rights. Through the emission of shares the company is able to reach a larger pool of investors.
The second advantage is the diversification of risk, both the systemic risk as the company specific risk (Denis et all, 1997, Demsetz et all, 1997)). Investors are liable only for their stake in the company and consequentially lose less money in case of economic downturn and bankruptcy. This does not eliminate the chance of losing invested funds, but it does diversify the risk over multiple parties.
The third advantage to this is that there can be knowledge synergies amongst the owners of the company. Wherever one owner can be incapable of dealing with a situation, multiple owners have a larger chance of possessing the necessary knowledge.
This ownership form however does come with disadvantages as well. Disagreements amongst the owners can lead to a rigorously steerless or indecisive company. A dominant owner can even direct the company into to personally beneficial practices that might be disadvantageous for the other owners. In essence the owners have lost the individual control over the resources of a company (Demsetz, 1983, Laeven & Levine, 2006). This can be amplified by the
differences in size of the relative stakes of owners (Mülbert, 2009). For instance, the dominant owner, Large Shareholder, Blockholder or Controlling Shareholder (Jensen & Ruback, 1983, Shleifer & Visnhy, 1986, La Porta, 1999, Jog et. all, 2010) of the company, can exert
political power over minority shareholders, simply because it has a larger stake in the
Page 11 The second disadvantage is that of parties who chose to be none-dominant and who
participate in free riding (Mülbert, 2009, Laeven & Levine, 2006). In case a company has many owners, some investors can lean back as others put in work to raise return on their behalf.
The organizations analyzed in this paper are the multiple owner companies, because first, the above explored dimension of ownership evidently has many implications for an organization (Demsetz & Lehn, 1985, Shleifer & Vishny, 1986, La Porta et all, 1999) and secondly
because the ownership facet of an organization in combination with their not uncommon large size in terms of sales, profits or operations (Shleifer & Vishny, 1986, Demsetz & Strahan, 1997), provides one the most compelling argument to the Principal Agency theory (Fama & Jensen, 1983, Klein, 1983). Since the term owners is rarely used in business literature anymore, the term owner will now interchangeably be used with shareholder, which is the more common way to refer to the ownership dimension.
2) Executive Management (EM)
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acts as an hired agent for the principal, is logically called the agent (Fama & Jensen, 1983). This separation of control from ownership itself, has the advantage of the owners having their hands free to engage in other activities elsewhere. Additionally, EM is educated in
management and can bring additional knowledge to the table through their acquired
experience in management, or in other words, EM is specialized in management. This could be a comparative advantage that might be absent from the pool of owners (Klein, 1983, Demsetz, 1997, Fama & Jensen, 1983). So now, with the separation of control from
ownership, management is left in charge of operating the company where the owners retain the right to the cashflows or the residual claims from the company. This means that the risk associated with the company rests with the shareholders, though some of it also with the creditors, but in return they receive the profits that might result from the operations. This will be further discussed in chapters 3 and 4.
3) Board of Directors (BOD)
The main downside to this is that EM is hired to do the job without bearing the risk of liability to the resources of the organization. In other words, the worst thing that could happen for the manager is that the organization goes bankrupt and the manager loses his job. For the owners however the consequences are farther stretching. They also lose the capital invested into the company and can be left with significant losses. The question that remains is how do the shareholders prevent Executive Management (EM) from slacking off or behaving in the interest of EM itself and not in that of the shareholders? Shareholders have introduced a third stakeholder into an organization to control for this, the Board of Directors (BOD). The
Page 13 the EM in the name of the owners. In effect, the BOD must ensure the alignment of
shareholders‟ interest with those of the EM, so that EM makes sufficient effort to obtain these interests of the shareholders.
The systems for controlling EM and the composition of the BOD differ somewhat in various parts in the world (Van Veen & Engelbertsen, 2008). The most evident difference is in the degree of separation of EM and BOD. In some parts of the world you find one-tiered boards, where the monitoring entity or the BOD is present at the same meetings and in the same corporate facet of the organization as is the EM. The two are in fact one, hence the name one-tiered board. However numerous studies have found that EM and the Chief Executive Officer are able to influence the monitoring party, which results in less thorough or biased
monitoring. This compromises the intrinsic reason for the existence of the BOD, that of aligning the interests of the shareholders with those of the EM.
So the dominant markets and indices nowadays have two-tiered boards as part of their listing requirements. The EM and BOD are separated from each other and a delegation of the EM reports back to the BOD. Note that the BOD is not present at the point in time where
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4) Creditors
To conclude this chapter of the paper, and in addition to the three above mentioned stakeholders, the creditors as the the fourth stakeholder deserve attention as well. The
problems arising between shareholders and management are in part mitigated by the existence of the BOD. This means that EM‟s interest should be sufficiently in line with the shareholders to ensure both have strong relations to each other. However, the interests of shareholders, EM and BOD differ somewhat from those of the creditors. The main interest of a creditor is that he wishes to receive a fixed interest rate on a fixed amount of money extended to the firm. And at the expiration date on the loan, he wished to receive back the principle amount of money on that particular loan (Mülbert, 2008, Denis et all, 1997). The creditors are therefore merely interested in the survival of the firm to such an extent that it can fulfill its obligations to the borrower (Ruah, 2010, Jiraporn & Kitsabunnarat, 2007, Cyert et. all, 2002). However, the return on investment for shareholders is flexible and related to the amount of risk that the organization participates in (Cyert et. all, 2002, Jiraporn & Kitsabunnarat, 2007). The higher the risk, the higher the potential reward for shareholders is. So the creditors must ensure that the company does not participate in too risky practices, for then the company can go bankrupt and the creditor would not receive any cashflows nor would it receive the principle sum anymore. There are different vehicles of debt, for instance senior versus subordinate debt and secured versus unsecured debt. The higher the seniority of the debt, and the better it is secured by assets or resources of the organization, the smaller the incentive of the creditor is to
Page 15 The problems arise for the subordinate debt, the debt which is unlikelier to be compensated for in case of bankruptcy (Park, 2000, Sironi, 2003, Ahmed, 2009). They have the incentive to minimize the gap of information asymmetry between them and the company through
controlling EM, to ensure the organization survives to fulfill its contracts. In case the BOD is completely independent from the company, and is no longer compensated for their activities by the shareholders, the interest of the BOD becomes the monitoring of the organization in general, which would include those of minority shareholders and creditors (Huang et all, 2008, Ahmed, 2009), thereby giving the extenders of subordinate debt a champion in the boardroom.
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Chapter 3: The Traditional View on Corporate Governance
Above here 4 stakeholders and their relation to each other have been introduced in the principal-agency framework. This chapter will provide one of the proposed views to the research question of how the independent variable of Corporate Governance influences the dependent variable Managements‟ Actions.
Corporate Governance is some form of a code of corporate conduct for all the above mentioned stakeholders. It is summarized as a set of rules and means to run a company besides the regulation instated by law. This chapter will elaborate on how the Traditional View on Corporate Governance works and who it is particularly aimed at. What this paper points out is that there is a The Traditional View on Corporate Governance which says that EM consists of inertly egocentric employees, who are searching for opportunities to extract wealth from the organization for their private benefit. The role of Corporate Governance is then to prevent EM from engaging in these value extracting activities through 1) contracting and 2) monitoring. Diagram 1 will give a graphic explanation of how this works.
For many years, the principal-agency theory, was considered the dominant theory of why corporate governance existed. The theory is a two sided argument. The shareholders of a company needed to ensure their interests were aligned with those of EM. Without the existence of Corporate Governance, EM is not entitled to any of the profits of the
organization. According to Fama & Jensen (1983), the people who do possess this right to the cashflow of an organization are called the residual claimants. When all expenses are paid, what remains is the profit or the loss on the operations of that organization, or also the
Page 17 form of motivation for EM to increase this residual claim, since EM is not yet part of the residual claimants. Therefore they lack an incentive to run the company as best possible, some profit is for them equal to much profit. This is bad for the organization since EM is
responsible for looking for business opportunities and comparative advantages to outperform its direct competitors. EM could be forced to meet targets and otherwise be fired, but it is found that coercion is not the best incentive to do a job. Therefore, the interests of
shareholders are not aligned with those of EM.
The second side to the argument is that EM bears neither risk nor any legal liability to the assets of the organization. In case the company would go bankrupt, EM would simply be out of the job and the shareholders would be left with paying for all incurred costs so far unpaid. In fact, the argument goes as far that without any liability to the assets of the organization, EM would extract wealth (Jensen & Murphy, 1990, Core & Larcker, 2002, Chalmers et all. 2006) from the organization to increase EM‟s private wealth, through their compensation schemes. They can ask as much money as they desire, and if the load becomes too much to bear for the organization, just walk away. Nonetheless, large firms are in need of EM and are willing to pay substantial amounts of money to attract highly capable people (Chalmers et. all, 2006).
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there are other corporate committees who look into the supervision of EM and here it will be explained to its full extent.
1. Contracting
There are 2 separate approaches to the contracting of management to solve the agency problem between shareholders and EM. The two approaches to contracting are the Optimal Contracting Approach (Bebchuk et. all, 2003, Bebchuk & Fried, 2002, Bebchuk & Spamann, 2009) and the Managerial Power Approach (Cyert et. all, 2002, Bebchuk & Fried, 2003, Ferranini & Moloney, 2005). Both however are subject to the contingencies of doing business and the economy situation in general (Klein, 1983, Franklin & Gale, 1992) .
a) The Optimal Contracting Approach
Contracts for EM are usually designed by remuneration committees, which consist of a delegation of directors from the BOD and not rarely externally hired consultants. In the Optimal Contracting Approach there is the belief that the BOD or remuneration committee can set a contract that incorporates all business practices of the firm and by this the contract can set sufficient incentives for EM to perform. The effort of this approach is to establish an intrinsic motivation for EM to reach high performance through reward schemes.
Page 19 personal wealth from compensation. The maximizing of their own reward becomes the intrinsic motivation for EM to reach high performance (Jensen & Murphy, 1990).
To ensure the effort of EM, this variable part of compensation is added to the already fixed part of executive remuneration. Variable pay comes in all shapes and sizes. Managers can be awarded bonuses for meeting targets, in which case the EM would for example receive an additional cash amount of pay. If targets are linked to turnover and/or operating profits, the EM should try to reach these goals. However, EM has the incentive to work as little as
possible and can manipulate the profits through the information asymmetry between them and shareholders. A consequence of this could be that EM receives its bonuses by smoothening income (Tseng & Lai, 2007, Grant et. all 2009), which is the accounting practice of balancing income in a way that the bandwidth between high and low income by spreading it over several years becomes narrower. This way EM is able to cash in bonuses by profiting on in the past retained results, that compensate for results in the present (Tseng & Lai, 2007, Grant et. all 2009). There is debate on whether this is harmful to an economy or even for an
organization itself (Wymeersch 2008, Allen & Carletti, 2008, Allen et all, 2004),
nevertheless the practice is illegal practically everywhere since it does not provide accurate data on organizational performance at present times. It can therefore be harmful to the organization in the sense that at the time of discovery by the markets, it is reflected in a drop in organization share value. EM still does not feel these consequences as severe as
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profit, the higher dividends awarded, the higher the price of the stock is on the market, the higher the variable part of his contract. However, there still is a downside to this
compensation package. The awarded stock still incorporates no liability to EM. If the value of the company falls by 50% during the time EM is in the service of the organization, though they would probably not receive any dividends over their stock, they would nonetheless still receive that 50% which is left from the original share price. The stock rarely ever becomes completely worthless and bear in mind that the variable part of compensation is added to the fixed part of pay. So, in case of a severe fall in share price of the company, the shareholders have lost a lot of value but the wealth of the EM has still increased. In fact, this practice has reinforced the agency problem through limited liability of EM, because EM receives the 50% of stock value on top of the original 100% fixed pay. The contract now establishes an
unlimited upside potential, for when for example stock prices rose with a 1000% making total pay of fixed plus variable 1100%. It also shields them from the downside potential for when the organization losses for example 75% of its value resulting in 100% fixed pay plus the 25 remaining percentages of stock value, making pay 125%. Additionally, if EM compensation is related to the performance of the company, EM will only engage in Positive Net Value
projects, because this is safe for EM (Kirkpatrick, 2009, Grant et. all, 2009). Investors prefer a riskier course of action. This will be further explained in the chapter The Modern View on Corporate Governance.
Page 21 that provide a right to a certain amount of shares at a certain moment in time for a certain value. If the shares underlying the options possess less value than the shares are worth on the market, the options is useless. The advantage of options is that they also remain worthless in case the share value of a company falls, making the variable part of pay worthless as well. The idea here is that their variable pay is related to not only the amount of profits, but also to what the market perceives of the organization. In the worst case scenario, when the company hits a corporate scandal and is not able to perform well, the variable pay could equal zero. Additionally, the effect of options compensation can be further enhanced if the options awarded are out-of-the-money. This is when the shares in the option are below the value of those currently trading in the markets. This effectively means that during the time of signing of the contract, the options are worthless. Through good management and operating
performance, EM has to increase share price on the market beyond that of the strike price of the options. If the markets agree with the course of action of EM and the organization‟s business performance, the market will reward the organization, its shareholders and therefore also EM, with a higher share price. The difference between at- or in-the-money options as opposed to out-the-money options is that EM has to bridge the gap towards becoming at-the-money before variable pay will obtain any value at all.
Under the Traditional View, EM consists of people who are interested in extracting wealth from the organization. Since their variable pay with out-of-the-options equals 0 at the time of signing, they have to cover ground before the expiration date of the contract. To increase the value of the organization and its shares they have to engage in company-specific risky
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the contracts, since fixed pay remains, the consequences of such risky projects going bad remain primarily on the shoulders of the combined shareholders. To prevent this,
organizations can impose holding times on awarded stock, stating that EM can cash in stock only from a pre-set future date after the expiration of the contract. For instance, these holding times can stretch as far as 5 years, before stock can be sold in the market. If risky projects turn out to be harmful to the organizations in the long-run, the stock rewarded to EM has a chance to devaluate over time along with the stock of normal more permanent shareholders.
An additional and already a more prominent solution designed to prevent the excessive risk-taking of EM is the establishment of standalone independent board level risk committees at an organization. This committee will be discussed later in this chapter under the header BOD and other monitoring entities.
b) The Managerial Power Approach
Page 23 (Del Rosal, 2011, Bebchuk & Fried, 2003, Bebchuk & Walker, 2002, Chalmers et. all, 2006). This makes the negotiating process on contracts in itself part of agency theory (Bebchuk et. all, 2003). This principal-agent contradiction in contract negotiation and the rent seeking behavior of EM, hold the basic principles for the Managerial Power Approach (Bebchuk & Walker, 2002, Del Rosal, 2011). All managers have some power over the organization they run, some more than others (Cyert et. all, 2002). The reason why boards were spilt up in the first place from one-tiered into two-tiered boards, was that EM was able to obtain excessive power on the organization through the manipulation of the monitoring entity in the board and therefore on the shareholders. The Managerial Power Approach recognizes that EM is also able to exert this same political power during the negotiation process on executive
remuneration. Powerful or charismatic Executive Managers, like CFO‟s and CEO‟s (Conger, 1990, Khurana, 2002, Hayward, 2004), can have strong influence on the negotiating process and therefore have the ability to receive higher compensation than they would relatively deserve compared to other EM‟s of competitors. They are more effective at rent extraction than their less powerful peers. Additionally they can use this political power to entrench themselves into the organization. They can make it contractually very difficult and expensive from an organizational and financial point of view for them to be fired (Bebchuk &
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c) Contingencies
What this part of thesis looks at is The Traditional View on Corporate Governance and the egocentric attitude of EM that is at the basis of this. So far there have been many contractual possibilities discussed. However, what even the earliest literature on Corporate Governance suggests is that contracting alone does not solve the agency problems between EM en shareholders. Even the most elaborate reward schemes still leave room for discussion on whether goals have been achieved and have ways of bypassing them to earn more reward than was deserved. Things like economic downturn, damage to organizational assets and
environmental disasters are also not able to be incorporated into the contracts. And to make matters worse, there is always the slight chance that fate intervenes and the organization suffers from well considered choices which turned out harmful. All these things are
contingencies (Fama & Jensen, 1983, Klein, 1983, Allen & Gale, 1992) and are impossible or too expensive to incorporate into a contract. There is no chance that a contract considers all the affairs that businesses are in and the effort of making such a contract can be excessively time consuming and hugely expensive under either of the contracting approaches.
2. Board of Directors and other Monitoring Entities
Page 25 a) Internal Monitoring
In the Chapter 2: Theoretical Framework, the BOD has been discussed to some extent, but merely in terms of their internationally differing cosmetic appearance. The difference between one-tiered and two-tiered boards was explained, but what is left is to explain what the BOD does specifically, what are the characteristics of the Directors in them, and why they do what they do. The Board of Directors is the most important and heavy internal monitoring entity of an organization and it has to be independent from EM to avoid bias. The BOD is hired to monitor EM on behalf of the shareholders and as such is appointed and compensated straight by the shareholders. They are in charge of overseeing the decisions made by their executive counterpart, have a reporting duty to the shareholders and can if needed veto EM‟s plans during a year of operations. To fulfill this job as well as possible, the BOD has regular recurring meetings with EM and has to be informed of the operations of an organization. At this point in the organization, the asymmetry of information steps in. EM has the ability to withhold, manipulated and distort information shared with the BOD, to influence the perception of BOD and the shareholders on the strategies and activities of the organization. Even though BOD has access to organizational files, if the EM has bad intentions it can hide information. To limit the gap between BOD and EM, BOD has some instruments to its disposal. First of all, the contracts of EM are designed, so that BOD has direct influence on what goals specifically mean and how they are supposed to be met. It is not uncommon for them to hire independent from the company external help to form the above mentioned
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smaller scale what financially is happening in the organization and they have the
responsibility to disclose this to the BOD (Krishnan & Visvanathan, 2009, Sherman et. all, 2009) . They have the capability to see how middle and upper management performs and are readily capable of assessing their individual performance. The more effective they do this, the better BOD is informed and is capable of making its judgments (Zaman et. all, 2011).
However, there are some issues here. The auditors are paid by the firm, so in what way are they truly unbiased (Park, 2007). Additionally, they operate on a day to day basis within the organization, therefore again, the opportunity arises for them to be biased (Park, 2007). But most importantly, the auditors have to be competent in terms of financial expertise (Krishnan & Visvanathan, 2009, Goh, 2009, Zaman et. all, 2011). This may sound logical, but there are very few formal or regulatory requirements to the composition of audit committees.
To add to the internal auditors and Audit Committee, the BOD can hire external auditors. They will be discussed to further extent under the external monitoring heading.
Page 27 profitable at the expense of a high potential of causing severe losses. Therefore BOD‟s, especially in the financial industries, are instating risk committees. They are in charge of informing the BOD of how much risk the organization is currently involved (Bugalla et. all, 2010). The emergence of the Risk Committees is the result of the global financial crisis, in which the EM of banks and other financial entities were engaged in large amounts of risk, for the sake of the opportunity of making large amounts of profits. Risk Committees are however due to the time expired after the crisis still a relatively undeveloped and new monitoring instrument.
Besides the instruments that the BOD has at its disposal, BOD itself should be a capable and effective board. The degree of BOD director independence (Ravina & Sapienza, 2010, McCabe & Nowak, 2008, Cook & Wang, 2011), gender and international diversity, and most importantly BOD competence (Hua & Thum, 2010, Cook & Wang, 2011) all have significant influence on the monitoring on EM. Highly diverse and educated BOD leads to more
competent BOD‟s because they have more readily accessible knowledge to interpret the information given to them by EM, the Auditors, and the Risk Committees. By this
competence they have better judgment on the organizations performance and EM‟s role in it.
b) External Monitoring
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Zaman et. all, 2011). However, these external audit firms have numerous conflicting agency points. A bad audit assessment from an external audit party has multiple implications. The organization suffers significant losses on firm value from such an assessment, but it has the reputational advantage of hiring a firm which is considered strict. In case a firm with a lesser reputation for being integer and thorough would be hired, shareholders and also potentially new investors have less trust in the assessment and in the organizations books (Craswell et. all, 1995). However, the reputation of the firm has a visa versa effect on the external firm as well. The reputation of thorough- and strictness, can backfire on them through the
organizations‟ fear of hiring the particular external audit firm. The firm can be too strict and therefore be hired less because of it (Jensen & Payne, 2005).
Page 29 This leaves us with the last monitoring entity, which is also the largest. The markets and indices themselves. External companies like credit rating agencies (CRA‟s) are at frontline of informing investors (Wymeersch, 2008, Kirkpatrick, 2009). In case EM extracts wealth from an organization, investors will come to know about it and the organization will be punished for it by the markets with a drop in share price. When considering that most contracts make EM part of the residual claimants, this would be highly un-recommendable for them.
Even though the last external monitoring entity is not a monitoring entity pur sang, it is as vast and important that every organizations has to deal with it. It is the government and its regulation. The US has instated the Sarbanes-Oxley act in 2002, and in it are many laws on Corporate Governance related issues. For example, it states for instance that Audit
Committees are now by law required. Additionally, governments provide anti-fraud laws and investor protection (John et. all, 2004, Valentina & Claessens, 2010) The rules however are different across the world, the US has a very solid legal enforcement on mandatory
compliance, or a comply or be punished approach (Jog et. all, 2010, Allen et. all, 2007). The EU on the other hand has a more comply-or-explain mentality (Jog et. all, 2010, Allen et. all, 2007).
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(Becher & Frye, 2011, Bebchuk et. all, 2009). This thesis just states that in the current business world, governmental regulation is far from universal across countries (Allen et. all, 2007, Jog et all, 2010), but nonetheless it is there. It is beyond the scope of this thesis to include all these different regulation systems.
This chapter has provided insight in how Corporate Governance influences EM‟s Actions in the light of the Traditional View. To summarize this chapter, we have found that according to this view, Corporate Governance is meant to prevent EM from being capable of or actually engage in the value extraction from an organization for their private benefits. Organizations and their shareholders have several means in addition to the externally imposed regulation, to do this. They have set proper goals to align EM‟s interests with those of the shareholders through contracting. After that, the gap of information asymmetry between the shareholders and EM has to be brought to a minimum, through monitoring entities, they check whether EM is performing well and provide guidance for decision making process for the BOD. If the mechanisms work and Corporate Governance is considered functioning, even though still wants to, it should not be able to exploit the organization anymore.
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Chapter 4: The Modern View on Corporate Governance
The previous chapter of the paper has shown the first perspective on Corporate Governance. In that perspective, Corporate Governance was mostly aimed EM and the systems an
organization can employ to reduce the likelihood that EM would exploit the organization. The nature of this view however requires that the organization and its shareholders itself are not in the business of achieving goals at the expense of stakeholders, or in simpler and more
informal terms, that they behave well. This is not the case as was made strikingly clear by the financial crisis. A critical part of the financial system was based on loans that were extended with borrowed money as well. Some investment organizations had recognized this and
engaged in shorting stock, which primarily meant that they were betting on the collapse of the system while still making large sums of money of it. Large non-financial organizations had taken part in elaborate organizational structures to limit the shareholders‟ risk, while still being able to engage in the taking of this risk.
This chapter will provide the Modern View on Corporate Governance, where Corporate Governance is no longer only aimed at the prevention of wealth extraction by merely EM, but also on a third agency problem related to this topic. In the Modern View, Corporate
Governance influences EM‟s action through the reduction of risk for shareholders, by influencing control and cashflow rights, who are therefore able to extract wealth from the organization at the expense other stakeholders (Mülbert, 2009).
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1973, Fama & Jensen, 1983, Klein, 1983). The second was, although just briefly mentioned in the Theory chapter, was the exploitation minority shareholders by Large, Controlling or Block-holding Shareholders (Jensen & Ruback, 1983, Shleifer & Visnhy, 1986, Jog et. all, 2010). The third agency problem is that because the Traditional View Corporate Governance mechanisms employed, shareholders and EM are a well-oiled machine capable of exploiting the remaining stakeholder in the organization, the creditors. They do this through the shifting of risk (Hovakimian et. all, 2003) from the shareholders and EM to the creditors while remaining the residual claimants of the organization. The first heading explores the concepts of Risk, Control and Cashflows (or residual claims). The second heading will take you through the consequences that these concepts have for the organizations‟ stakeholders by explaining leverage and limited liability. The third heading then shows how EM and shareholders are able to manipulate leverage and limited liability to their full extent by explaining Layered Levered Organisation, Hub Levered Organizatons, Pyramid Structured Organizations & tunneling of funding, RVS, and the moral hazard concept.
1. Risk, Control & Cashflows
Page 33 provides. Stepping into a well-known market, would provide the owner with a high chance of surviving and taking on low risk but on the opposite side he would have to be content with a small proportion of that market and consequentially low potential rewards of doing business. If he were to invest in a smaller niche or new and undeveloped market, the potential rewards of this step exceed those of the safe choice. The clients of the organization are participating in a scarce resource and are willing to pay premiums for it. The disadvantage is that he is taking a risky course of business, since chances are that the undeveloped market does not develop and there is no growth or generation of profits at all. The taking on of additional risk has broadened the bandwidth between potentially high residual claims and potentially substantial losses. The owner now has to search for a solution to tap into those potentially high profits and eliminate the downside potential of the associated risk with it.
This owner has 4 options now: Continue to run the business without expanding and using the residual claim for private use, but run risk of scale disadvantageous turning on him and the cost-benefit bandwidth remaining narrow. Every increase in the residual claim through this investment, would be the direct right of individual shareholder.
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Thirdly, if the shareholder does not want to partake in the increased risk of bankruptcy, he could expand by selling stakes in his organization to gain excess to additional liquidity to invest. This would expand the assets of the organization without the primary shareholder taking on extra risk. This goes at the expense of him losing some of the control of the company and sharing the residual claim. In the case of 4 shareholders, the owners bear 25% of the risk in the organization and for that 25% they have a right to 25% of the residual claim in that organization.
Or fourth if the shareholder wishes to expand, but remain the sole controller of the company and recipient to the residual claim, he could borrow money. The owner or borrower takes on debt and by doing this is responsible for paying an interest rate to compensate for the
Page 35 considered to be the source of value creation of organizations (García-Feijóo & Jorgensen, 2010, Dang, 2011).
With no borrowing, an owner invests 100% of the funds in an organization and be entitled to 100% of the residual claim. In case the same owner borrows money and now is responsible for just 25% of funds in the company, he still is the only recipient of the residual claim, even though some of it has to be paid as interest. It becomes interesting for the owner when the residual claim of the company starts increasing faster than that of the interest burden it has to bear. The debt could have been scaled to a by 50% increased residual claim. If the assets purchased by the debt are in fact producing a 200% increased residual claim, the additional 150% extra goes directly to the owner.
2. Leverage & Limited Liability
There are several consequences to leveraging an organization. By increasing the sum of funds in the company and simultaneously maintaining the cashflow and control right ratios intact, the risk has shifted from the owners to the creditors. The shareholders are responsible only to the investment made by them in the past, which makes the shareholders liable to a certain limit. In the financial and business literature this is called limited liability (Muchlinski, 2010, Toporowski, 2010, Budde & Kräkel, 2011). Should the organization go bankrupt, the
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Kräkel, 2011). This shield against risk can lead to severe corporate irresponsibility reflected through the decisions made by EM (Ireland, 2010, Muchlinski, 2010)
The theory still applies to even major business concerns, with large quantities of shareholders and large proportions of debt. The mechanisms described under the chapter 3 align the
interests of EM with those of the shareholders, therefore we can say that within the model of this thesis with four stakeholders and ceteris paribus, they behave as one group. This is the basis for exploitation of wealth from the organization at the expense the creditors.
Shareholders and therefore EM are able to strengthen this limited liability and leverage by several organizational structural designs and the kind of debt they take on. These will be discussed in the following heading.
3. Strategies for the exploitation of the Creditor
The keywords to leverage and Limited Liability are 1) risk, 2) control and 3)
Page 37 There are several generic strategies which shareholders can use to exploit the organizations creditors and other stakeholders. The first strategy describes they relation to equity and debt. The second strategy is that of multiple layers of leverage through Layered Levered
Organizations, Hub Levered Organizations and Pyramid Structure Organizations. The third strategy comprises Restricted Voting Share structures or dual-class share structures. The fourth is the selection of certain creditors and by it influencing the nature of the debt
incorporated into the debt. The final strategy is acquiring significant importance to financial systems, by deploying the moral hazard principle to their advantage.
a) The first instrument that shareholders and EM have to influence either one of the three variables to leverage is to take on so much debt, that the initial investment into the company becomes such a small proportion of the total assets of the company that the risk of bankruptcy becomes almost neglectable. The end result is that EM can participate in very risky projects and not suffer much damage in case the company is not able to generate sufficient return. Obviously this is not very efficient for the creditors, so from a certain point on, firms are not able raise additional debt at acceptable interest rates anymore. This option reflects the reduction of risk of bankruptcy for shareholdings.
b) The second vessel EM and shareholders have at their disposal is structurally change the organization by increasing leverage and decreasing liability further by rearranging control, through making a secondary organization under control of a mother company.
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any other organization. With the combination of this equity and debt, the mother organization than purchases all the equity in an secondary organization together with the control and cashflow rights associated with that equity. The mother company thereby in fact decreases its liability to just the equity share it has in the mother organization. For example, the mother company has an equity-to-debt ratio of 20% equity and 80% credit. The 20% equity has a 100% control and a 100% cashflow rights as is usual for shareholders, and now with the combined funds in the mother company purchases all the equity in the secondary organization. The second organization has 10% equity and 90% debt and all the control and cashflow rights of that organization lie within those 10% equity. This means that with 20% equity investment in the mother company, the shareholders of that company were able to purchase a 100% of equity in the second company. Or, for the price of an initial investment of 20%, they were able to increase its leverage to .2 x .1 = .02 for the whole
organization. In case the secondary company bankrupts, the EM and
shareholders of the mother company are liable only to those .02 percent in the organization. In this example, through structurally changing the organization the shareholders have decreased the limits to their liabilities over the
organization by a factor of 10. The extent to which the organization repeats this practice, defines its liabilities. For instance, when the leverage waterfall
Page 39 finance and the attractiveness of funding a to-the-4th-degree levered company is not very high.
A variation to strategy, with a slightly different character, is what this thesis will call the Hub Levered Organization (HLO, diagram 4). The LLO is a waterfall of leverage from top to bottom, where the risk is diminished by the reduction in liability. The HLO provides other opportunities for the
shareholders extraction of wealth from creditors, through risk diversification of the levered mother organization. The organization is levered on itself, but now purchases a variety of other levered organizations. Besides the benefits it receives from limiting its liability, it is now also betting on multiple projects, effectively diversifying its company specific risk over several daughter organizations. If the success of a small fraction of those companies compensates for the failures of the others, the shareholders in the mother organization are content and the bankrupt companies become collateral damage.
The third type of levered organization is the Pyramid Structured Organization (PSO, diagram 5). The advantages for shareholders of the mother organization are maximized by a combination of the LLO and the HLO. This type of
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through diversification. What makes this organizational form distinctly different from the other two, is that the organizations in the second line also engage in the purchase of levered other companies, either alone or through a combination of effort of multiple second degree companies. By this a third level of the organization is generated, with cross holdings (Claessens et. all, 2002) and shared liability over second degree HLO‟s.
The benefits of this type of organizational structuring, besides the reduction of risk and liability at the mother company, are that the organizations can cross-fund or tunnel funds into companies where there risky projects are generating residual claims (Morck et. all, 2005, La Porta et. all, 1999). The overseeing mother company has the ability to recognize where this generation of profits is taking place and can than steer the money through the second and third degree HLO‟s to this place.
Claessens et. all (2002), have found that this structure means a lower firm value of all the companies under the umbrella of the mother company, but nonetheless the mathematical potential is great. A possible explanation for this finding is that shareholders and creditors in second and third degree HLO‟s value their shares and extended credit less because of the reduced risk and liability for the shareholders above them in the PSO. A lower share price and higher interest rate reflect the added risk the shareholders and creditors in those organizations are exposed to.
Page 41 these above mentioned organizations stems from the redefinition of control, resulting in reduced liability and risk.
c) The above two instruments are aimed at rearranging the combination of control and cashflows in such a way that liabilities and risk are reduced. The third instrument however takes place in just the control variable of the model, through Restricted Voting Share (RVS) or dual-class share structure. The idea of this instrument is to extend certain privileges to shares and thereby creating different classes of shares (Jog et. all, 2010, Lauterbach & Yafeh, 2011, Bebchuk et. all, 2002). In this case, control is fit into a small proportion of the shares; while still have a large share of votes of the company. In case when there are shareholders with a large risk appetite, like shareholders in a PSO, they have the ability to steer the
organization into risky projects. Undiversified and/or unprotected other shareholders with the remaining minority stakes of control, can be rewarded extra dividends for the accumulated risk they are exposed to. Again, in case the minority shareholders have done their due diligence on the company, the extended dividends have to be high if the company is further down the chain of control and leverage of the mother company. At some point, the risks for holders of none controlling shares have become so large, that the rewards accompanying them are not profitable for the controlling shareholders anymore.
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the most efficient debt for EM to take on in term of time is not clear. Jiraporn &
Kitsabunnarat (2007) state that EM prefers short-term debt since it implies the disinterest of the creditor due to the short length associated with the debt. Cyert & Kang (2002) on the other hand state that short-term debt is the opposite of disinterested, since it is easy to monitor and he has to make sure that the organization survives that brief duration of the debt. The
literature however is clear on the distinction made in the levels of seniority. Any level of seniority diversity is undesirable for EM (Ahmed, 2011, Cyert & Kang, 2002, Rauh & Sufi, 2010). Debt which is senior to other debt and gets awarded compensation the first in case of bankruptcy is lazy in terms of monitoring EM and the organization. Subordinate debt however has to make sure that there is no bankruptcy at all, since this would imply their share of
funding in the organization to dissolve. The subordinate debt is inclined to monitor the organization thoroughly, to make sure their debt retains its value.
e) The last strategy which EM and shareholders can employ is something which arises out of coincidence, but once it happens it yet provides another means for limiting liability. When an organization becomes so big that it has become a significant part of a financial network, then its size and its place within that network can be the motivation for governments not to let them go bankrupt at all. This is known as the moral hazard phenomenon (Allen et. all, 2007, Demsetz et. all, 1997). It happens when an organization has so many assets in other
with-Page 43 bankruptcy-threatened entity with emergency funding. For instance, AIG in the USA, BNP Paribas in France, and ABN Amro and Aegon the Netherlands were bailed out by their
representative governments. However, having become such a too-big-to-fail organization, EM and shareholders are now completely shielded from any repercussions to their acts, so there are no preventions left for them to take excessively projects.
There are still few remedies against the strategies, besides subordinate debt issuance and completely financially and organizationally independent BOD‟s. The latter of the two has the benefit of creating a party which stands above EM, shareholders and creditors. The main disadvantage is, who will pay for their rendered services if they would be compensated at all. Any compensation would result in the emergence of another agency issue, since there would be compensation negotiations where the BOD would be a party in. After the negotiations have taken place the party who pays BOD, becomes the most influential party in the organization or so it appears from an agency perspective.
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regulation are currently adapting to this worst case scenario, to prevent the coming about of such events. To summarize, the variables of 1) risk, 2) control and 3) cashflow/residual claims influence the degree to which a company is liable and levered. There is a high degree of endogeneity to the model, because both sides of the model have influence on each other, in the sense that also Limited Liability and Leverage have a significant influence on the other three variables. However, even when this is the case, this model does confirm that EM is not the only one able to extract wealth for personal benefit from an organization, even though shareholders do it by other means with differing results. EM is capable of influencing their direct compensation and personal wealth. Shareholders on the other hand are not able to do this; they can only indirectly maximize the upward potential of their investments while
limiting their downside potential. The strategies that shareholders have for this are such clever engineered instruments, that the success associated with the tactics has been a reason for the increasing standards of wealth in the world. However, these investments have a high
possibility of running an organization to the ground, although shareholders are no longer affected by this since they use the organization as an empty shell or profit making vessel for wealth expansion.
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Chapter 5: The Social Psychological View
The previous 2 chapters have addressed the model of how Corporate Governance influences EM‟s actions from a finance stance. In the current literature on Corporate Governance there are also additional streams, which address Corporate Governance from a different angle. These streams come from business and social psychological ideologies. In the applied financial work, Corporate Governance is all about providing EM with correct incentives to prevent EM and shareholders from extracting wealth from the organization. In this case the keyword of the applied financial views is incentives. So what motivates EM and shareholders to do this is some intrinsic and extrinsic influences. What this thesis has not discussed yet is where these influences come from and how Corporate Governance influences them.
In Chapter 4: The Modern View, it is discussed that after the alignment of EM‟s and shareholders‟ interests, they collaboratively found means to exploit the creditors of an
organization for their own benefit, through Leverage and Limited Liability and that Corporate Governance itself is not yet fully equipped to prevent this from happening. Under the
Traditional View, it was sought to restrict EM‟s actiosn. This worked to the extent that Corporate Governance aligned EM and shareholders. Under the Modern View, Corporate Governance itself is an antecedent of organizational misconduct. Some solutions have been proposed like the reorganization of capital requirements in the Basel conferences, but many have not yet been addressed. Under the third approach called the Social Psychological View, EM is not chained at all; they retained their bad intentions to extract wealth from the
Page 47 The main tools for this are Impression Management (Westphal & Graebner, 2010), and Stealth and Camouflage compensation (Bebchuk & Fried, 2004). Impression Management means that EM takes all the prescribed measures to insinuate their compliance to required Corporate Governance guidelines, but in reality is hiding behind this façade. For instance, Westphal & Graebner (2010) have found that the instating of a BOD itself does not
necessarily solve the agency problems it was intended to solve. For BOD to mitigate agency issues in an organization, it needs to have control over EM. When EM does instate a BOD but never hands it the control it needs, the BOD remains an empty entity with no power to
monitor. Another form of this was the appointment of outside Directors (Westphal & Graebner, 2010). The sheer fact that there are outside Directors present in an organization, suggests good Governance. However if these Directors or the BOD gain no additional power, the EM gains support for their actions without any increase in their responsibility. Outside investor might now be under the impression that Corporate Governance is functioning at this organization, while in the mean time things progress the way they used to.
A similar goal is achieved by EM with the practice of Camouflaged or Stealth Compensation (Bebchuk et. all, 2004). In these compensation arrangements, it appears for outside investors as if EM has tightly negotiated contracts, but really they have reward schemes which are difficult to track down. Golden Parachutes were one of the stealth compensation instruments (Bebchuk et. all, 2004, Davis & Greve, 1997). Initially Golden Parachutes themselves were meant as a Corporate Governance mechanism, to prevent the ditching of top executives in large organizations after takeovers. Consequentially, a takeover or acquisition of an organization would become more expensive. However for organizations that did not
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themselves were finding that it was hard to get rid of ill-functioning executives, since EM had substantial severance packages.
What the Social Psychological View adds to the Traditional and Modern view is that it explains where the intrinsic motivation of EM and shareholders come from, to exploit an organization for its resources from a sociologist angle. Research states that is mostly because EM overestimates their capabilities turn make risky projects profitable and therefore deserves high rewards (Chatterjee & Hambrick, 2007, Hayward & Hambrick, 1997). The concept of EM hubris (Hayward & Hambrick, 1997) and Narcissism (Chatterjee & Hambrick, 2007) provide evidence for actions of EM. An example is provided by a takeover scenario. Some state that takeover scenario‟s provide a market control mechanism. In case the value of an organization would drop to or under a certain point, the organization would be subject to a threat of being acquired by another organization. However, Hubris and Narcissism have been linked to the search of acquiring EM‟s for targets. Hubris and Narcissism lead to
overestimating the acquiring organizations abilities to turn around a suffering target. EM can perceive themselves as the saviors of the target, while really they are no more competent than the EM of that acquired target. Even the prices paid for targets are connected with the
Narcissistic and Hubris nature of EM. The overestimating of their capabilities will lead them to pay excessively large sums for a company, well over the market value of an organization. If they can in fact boost the target‟s performance, profits will be significant. But again, with risky projects the chance of failure is higher than the chance of success.
Page 49 take on excessively risky projects like acquisitions over market value by leverage and Limited Liability, without any inhibition by BOD which is an impressionistic instated measure. And in case of failure, still be rewarded through Golden Parachutes.
The practices like stealth compensation and impression management have spread throughout the business world. Interlocking directorates and networks have provided channels through which the practices have come to be generally accepted standards. Interlocking directorates (Van Veen & Kratzer, -, Kentor & Jang, 2004) is the sharing of BOD directors between organizations. One director might be appointed to as much as 4 (or more) different BOD‟s and therefore is present in 4 (or more) different organizations. Also the closer organizations are to each other on a geographical scale, the likelier they are to mimicking each other‟s Governance practices. So the networks (Davis & Greve, 1997, Davis, 2005) executives and directors are part of, provide important facilities for the spreading of Governance practices, even the ones which have not been linked to increased organizational performance. If a certain network with high geographic proximity, a high degree of interlocking directorates and status, instates certain Governance practices, it is likely that the practice will be adopted by other markets as well. This is how the LLO, HLO and PSO were made publically accepted organizational structures.
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Chapter 6: Results and Discussion.
In this chapter you can find the results to the literature research this thesis represents. As was said in chapter 1: Introduction, the financial crisis was catalyzed through a series of financial organizations that took too much risk. There is however a note to be made to the three view on Corporate Governance. Organizations have shielded themselves from liabilities and risk to maximize returns on their investments, and they possess a whole series of instruments to do this. However, the source of the desire to create returns beyond those of your competitors or the creation of supernormal profits lies not only in the intrinsic motivation of shareholders in a firm. There is an extrinsic impulse from the markets as well. From a very generic point of view, you could consider an organization as a vessel for the making of returns without any emotional attachments; it becomes an financial instrument in itself. This is fundamentally different from the angle this thesis uses. This thesis considers the investments of the organization as the creator of returns as opposed to the organization as a whole being that creator. There is a subtle difference in it, that with the first view point individual investments possess risk and with the other the sum of the investments as a whole, bear risk through the organization. Markets reflect the collective opinion of investors of the organization‟s risk profile and its business performance. High performance with low risk, is rewarded with high company valuation. So, the motivation to engage in Limiting Liability and Layered Leverage can stem from the extrinsic motivation provided by the markets itself. If a company does not out perform its competitors, that news alone could ruin its stock price.
Page 51 of highly risky instruments, the instruments of 1) credit default swaps and 2) Mortgage backed securities will be discussed here.
The credit default swap is where a company, Company A, has an outstanding debt of 100. The chance that the borrower will default on this debt is great and the company will incur a loss when he does. He will not be able to pay the full price for his debt and whatever remains unpaid, is the direct loss for a company and diminishes its residual claim. However, company B is specialized in making sure that borrowers pay. It offers to buy the particular debt from company A for 80 and along with it the risk that the borrower defaults. There are now two possibilities, either the company losses the whole 80 it has spent on the buying of the contract, or it makes 20 when they were able make the borrower pay in full. However, for the financials this was not enough. Imagine the same debt, sold 5 times from organization A to B to
eventually E, with same face value of 100, which was bought for 50 after 5 other
organizations have put effort in the prevention of default by the borrower. The risk is huge for this one project, but an organization can make a 100% return on investment in case the
borrower pays up. On the other hand, it is highly likely that the borrower will default and the incurred loss in that case would be just as substantial.
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that many others. The same applies to mortgage backed securities, where company A bought securities with a loan. In case the securities go up, it is able to make a profit and pay back the mortgage. However, if the market in general finds itself in crisis and the price of the bought securities fall, let‟s say during a financial crisis, the securities are worth a substantially less amount of money than before and Company A now cannot repay the debt any longer. It has to cut in its private reserves to reimburse the debt. Again, in the financial crisis, company A had a lot of these instruments and defaulted on many and as soon as it ran out of reserves, it went bankrupt. Consequentially, Company B, incurs the loss of the debt defaulting. If company B had predicted it and sold the debt to C, who sold it to E, the circle with an added credit default swap becomes round. The point here is that there was a possibility of generating money with borrowed money and since investors are sheltered from liabilities in case it would go wrong, they participated in the trading of instruments like the credit default swaps and mortgage backed securities. Therefore, it is hard to pinpoint how much this extrinsic motivation implied by the markets, is a cause of taking these risky investments.
This brings us to the answering of the research question “How does Corporate Governance affect EM’s actions”. Under the Traditional View we have found that EM participated into the extraction of value from the organization if Corporate Governance would not prevent it. Corporate Governance under the Traditional View therefore seems a disciplinary instrument for EM‟s actions. Under the Modern View we have found that the Corporate Governance influences EM‟s actions in the sense that it has aligned the interests of shareholders and EM, resulting in capabilities of partaking in very risky projects through various strategies.
