978-1259709685 Chapter 1 Lecture Note Part 2

subject Type Homework Help
subject Pages 7
subject Words 1805
subject Authors Jeffrey Jaffe, Randolph Westerfield, Stephen Ross

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Slide 1.15 The Agency Problem
A. Agency Relationships
The relationship between stockholders and management is called
the agency relationship. This occurs when one party (principal)
hires another (agent) to act on their behalf. The possibility of
conflicts of interest between the parties is termed the agency
problem.
B. Management Goals
Slide 1.16 Managerial Goals
Direct agency costs – compensation and perquisites for
management
Indirect agency costs – cost of monitoring and sub-optimal decisions
Lecture Tip: In the early 1980s, the Burlington Northern Railroad
sought to sell off real estate with a value of approximately $778
million. The firm was enjoined from doing so, however, by
restrictions written into covenants of the firm’s bonds in 1896.
These were very long-term bonds with an additional fifty years to
maturity. They also were not callable and did not include a sinking
fund provision. Management found it necessary to negotiate with
the bondholders to release some of the value tied up in the real
property originally used to secure these bonds. Following a great
deal of legal wrangling, the bondholders settled for payments
totaling $35.5 million. Lawyers for the bondholders settled for
another $3.4 million. In other words, the cost of addressing this
stockholder/bondholder conflict was nearly $40 million – and this
doesn’t include the opportunity cost of management time spent on
this issue instead of running the business. For further discussion of
this case, see “Bond Covenants and Foregone Opportunities” by
Gene Laber, in the Summer, 1992 issue of Financial Management.
Ethics Note: When shareholders elect a board of directors to oversee the
corporation, the election serves as a control mechanism for
management. The board of directors bears legal responsibility for
corporate actions. However, this responsibility is to the
corporation itself and not necessarily to the stockholders
(“Sarbox,” discussed below, has somewhat changed this issue).
Although it happened several years ago, the following example
still makes for an interesting discussion of directors’ and
managers’ duties:
In 1986, Ronald Perelman engaged in an unsolicited
takeover offer for Gillette. Gillette’s management filed litigation
against Perelman and subsequently entered into a standstill
agreement with Perelman. This action eliminated the premium that
Perelman offered shareholders for their stock in Gillette.
A group of shareholders filed litigation against the board of
directors in response to its actions. It was subsequently discovered
that Gillette had entered into standstill agreements with ten
additional companies. When questioned regarding the rejection of
Perelman’s offer, management responded that there were projects
on line that could not be discussed (later revealed to be the
“Sensor” razor, which was one of the most profitable new ventures
in Gillette’s history up to that time). Thus, despite appearances,
management’s actions may have been in the best interests of the
firm, and this case indicates that management may consider
factors other than the bid when considering a tender offer.
C. Do Managers Act in the Stockholders’ Interests?
Slide 1.17 Managing Managers
Managerial compensation can be used to encourage managers to act in the
best interest of stockholders. One commonly cited tool is stock
options. The idea is that if management has an ownership interest
in the firm, they will be more likely to try to maximize owner
wealth.
Lecture Tip: A 1993 study performed at the Harvard Business School
indicates that the total return to shareholders is closely related to
the nature of CEO compensation. Specifically, higher returns were
achieved by CEOs whose pay packages included more option and
stock components. (See The Wall Street Journal, November 12,
1993, p. B1). However, this may not even be the best way to
encourage managers to act in the stockholders’ best interest.
Stern Stewart & Company has developed a tool called EVA®, which
measures how much “economic value” is being added to a
corporation by management decisions. According to Stern-
Stewart’s web site (www.sternstewart.com), companies that tie
management compensation to EVA® significantly outperform
competitors that do not. They are conducting ongoing studies to
measure this performance, but the preliminary data indicate that
the stock returns for these companies have outperformed their
competitors by a significant amount.
Both of these examples illustrate that carefully crafted
compensation packages can reduce the conflict between
management and stockholders. However, the option backdating
scandal may provide a point of discussion for possible downfalls of
such approaches.
Lecture Tip: According to The National Center for Employee Ownership,
broad based stock option plans have increased dramatically, not
only for technology firms, but also for non-tech firms such as
Starbucks and the Gap. Some firms have found a way to provide
stock-based incentive to employees without giving them equity
ownership at all. As reported in the October 26, 1998, issue of
Fortune, “phantom stock” is used by private companies such as
Kinko’s and Mary Kay, Inc., as well as public companies, to
provide employees with an incentive to work harder. Generally, an
employee is awarded “shares” on a bonus basis, and the share
values increase if the value of the business increases. (For a
private firm, this means obtaining outside appraisals of value
based on earnings multiples, etc.) At some future point, the
employee has the right to cash in his “shares.”
Stockholders technically have control of the firm, and dissatisfied
shareholders can oust management via proxy fights, takeovers, etc.
However, this is easier said than done. Staggered elections for
board members often make it difficult to remove the board that
appoints management. Poison pills and other anti-takeover
mechanisms make hostile takeovers difficult to accomplish.
Stakeholders
Stakeholders are other groups, besides stockholders, that have a
vested interest in the firm and potentially have claims on the
firm’s cash flows. Stakeholders can include creditors,
employees, customers, and the government.
Lecture Tip: A good practioner-oriented discussion of the
impact of stakeholders on decision-making is found in a 1987
Wall Street Journal article by Charles Exley, Jr., then-
chairman and president of NCR Corp. The thrust of Mr. Exley’s
comments is that giving more consideration to the interests of
non-stockholder stakeholders is good business and results in
the decentralization of management. Frequently, a discussion
of stakeholder interests (as opposed to a discussion exclusively
geared toward stockholder interests) leads to a better
understanding of the nature of the corporate form of
organization, the role of the corporation in society (and the
question of “corporate social responsibility”), as well as the
role of contracting in the labor and financial markets.
Ethics Note: A discussion of stakeholder interests leads very
nicely into a discussion of ethical decision making. Theories of
ethical behavior focus on the rights of all parties affected by a
decision, not just one or two. The “utilitarian” model defines
an action as acceptable if it maximizes the benefit, or
minimizes the harm, to stakeholders in the aggregate. The
“golden rule” model deems a decision ethical if all
stakeholders are treated as the decision maker would wish to
be treated. Finally, the Kantian “basic rights” model defines
acceptable actions as those that minimize the violation of
stakeholders’ rights.
Lecture Tip: The antitrust case against Microsoft can generate
a healthy discussion of ethical behavior, innovation and the
government’s role in monitoring business practices. The basic
idea behind the case is that: (1) Microsoft stifled competition
by imposing stiff penalties on computer manufacturers that
chose to install operating systems other than Windows on some
of their machines; (2) Microsoft tried to put Netscape out of
business by incorporating Internet Explorer into the operating
system; and (3) Microsoft has an unfair advantage in the
applications programming area because their programmers
have access to the source code for the operating system. There
were other issues as well, but these were the major ones. The
Judge in the case originally found that Microsoft did violate
antitrust laws and that they continued to operate in a
monopolistic fashion. He ordered the break-up of Microsoft
into an “operating system” company and an “applications”
company. The Judge also ordered that Microsoft allow
programmers from the Company’s competitors to come to a
secured location and view the source code for Microsoft
Windows. Microsoft contended that this would allow other
companies to determine the direction that Microsoft is moving
with their software and eliminate the competitive advantage
that their research and development has afforded the company.
The case was appealed and Microsoft was still found in
violation of antitrust laws, but not to the extent found in the
original case.
The Final Judgment was issued on November 12, 2002 and
has the following components: (1) Microsoft cannot retaliate
against an Original Equipment Manufacturer (OEM) if the
OEM “is or is contemplating developing, distributing,
promoting, using, selling or licensing any software that
competes with Microsoft Platform Software” or ships a
computer with more than one operating system; (2) Microsoft
must publish and use a consistent licensing agreement
schedule with all covered OEMs; (3) Microsoft cannot restrict
OEMs from selling computers that include competing products,
display competing product icons on the desktop, and launch
competing products when a Microsoft application would
normally be launched; (4) Microsoft must allow Independent
Software Vendors (ISVs), Independent Hardware Vendors
(ISDs), Internet Access Providers (IAPs), Internet Content
Providers (ICPs) and OEMs access to Windows Operating
System Product source code as necessary to develop products
that will work effectively with the operating system – these
companies must demonstrate why they need access and they
are limited to access to that code that is required for
“interoperating” with the operating system; and (5) Microsoft
is not required to disclose any intellectual property rights
related to security or that is designed to prevent software
piracy.
The Final Judgment called for the appointment of a
technical committee that will assist in the enforcement and
compliance with the judgment and Microsoft was required to
appoint an internal compliance officer to make sure that all
employees of the firm understand and comply with the
judgment. Reports on compliance are routinely filed with the
Department of Justice and can be found, along with the Final
Judgment, at http://www.usdoj.gov/atr/cases/ms_index.htm.
1.2. Regulation
Slide 1.18 Regulation
Historically, most regulation has focused on the disclosure of relevant
information, thereby putting all investors on an equal playing field.
A. The Securities Act of 1933 and the Securities Exchange Act of
1934
These Acts provide the basic regulatory framework for the public
trading of securities in the United States. The 1933 Act focuses on
the issuance of securities, while the 1934 Act established the SEC
and addressed other regulatory issues, such as insider trading and
corporate reporting.
B. Sarbanes-Oxley
Following the scandals at Enron, WorldCom, and Tyco, among
others, “Sarbox” was enacted in 2002. This Act significantly
increased the auditing and reporting requirements that public firms
face, and it also explicitly placed the responsibility for any fraud
on the corporate directors.
As with any law, however, there is a cost. In response to the added
burden, many (particularly small) firms have delisted and others
have foregone going public. For others, the cost of compliance has
significantly increased, thereby reducing profits.
Slide 1.19 Quick Quiz

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