978-1259709685 Chapter 1 Lecture Note Part 2

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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