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Reveal Markets are
information efficient and
honestly and assess effect of
on time news on value


Maximize Stock Prices: Real World Conflicts of Interest
Even a casual perusal of the assumptions that we need for stock price
maximization to be the only objective when making decisions suggests that there are
potential shortcomings in each one. Managers might not always make decisions that are
in the best interests of stockholders, stockholders do sometimes take actions that hurt
lenders, information delivered to markets is often erroneous and sometimes misleading
and there are social costs that cannot be captured in the financial statements of the
company. In the section that follows, we will consider some of the ways in which real
world problems might trigger a break down in the stock price maximization objective.

Stockholders and Managers
In classical corporate financial theory, stockholders are assumed to have the
power to discipline and replace managers who do not maximize their wealth. The two
mechanisms that exist for this power to be exercised are the annual meeting, where
stockholders gather to evaluate management performance, and the board of directors,
whose fiduciary duty it is to ensure that managers serve stockholders™ interests. While the
legal backing for this assumption may be reasonable, the practical power of these
institutions to enforce stockholder control is debatable. In this section, we will begin by
looking at the limits on stockholder power and then examine the consequences for
managerial decisions.

The Annual Meeting
Every publicly traded firm has an annual meeting of its stockholders, during
which stockholders can both voice their views on management and vote on changes to the
corporate charter. Most stockholders, however, do not go to the annual meetings, partly
because they do not feel that they can make a difference and partly because it would not
make financial sense for them to do so.1 It is true that investors can exercise their power
with proxies2, but incumbent management starts of with a clear advantage3. Many
stockholders do not bother to fill out their proxies, and even among those who do, voting
for incumbent management is often the default option. For institutional stockholders,
with significant holdings in a large number of securities, the easiest option, when
dissatisfied with incumbent management, is to vote with their feet, i.e., sell their stock
and move on. An activist posture on the part of these stockholders would go a long way
towards making managers more responsive to their interests, and there are trends towards
more activism, which will be documented later in this chapter.

1 An investor who owns 100 shares of stock in Coca Cola will very quickly wipe out any potential returns
he makes on his investment if he flies to Atlanta every year for the annual meeting.
2 A proxy enables stockholders to vote in absentia for boards of directors and for resolutions that will be
coming to a vote at the meeting. It does not allow them to ask open-ended questions of management.
3 This advantage is magnified if the corporate charter allows incumbent management to vote proxies that
were never sent back to the firm. This is the equivalent of having an election where the incumbent gets the
votes of anybody who does not show up at the ballot box.

The Board of Directors
The board of directors is the body that oversees the management of a publicly
traded firm. As elected representatives of the stockholders, the directors are obligated to
ensure that managers are looking out for stockholder interests. They can change the top
management of the firm and have a substantial influence on how it is run. On major
decisions, such as acquisitions of other firms, managers have to get the approval of the
board before acting.
The capacity of the board of directors to discipline management and keep them
responsive to stockholders is diluted by a number of factors.
(1) Most individuals who serve as directors do not spend much time on their
fiduciary duties, partly because of other commitments and partly because many of
them serve on the boards of several corporations. Korn Ferry4, an executive
recruiter, publishes a periodical survey of directorial compensation and time spent
by directors on their work illustrates this very clearly. In their 1992 survey, they
reported that the average director spent 92 hours a year on board meetings and
preparation in 1992, down from 108 in 1988, and was paid $32,352, up from
$19,544 in 19885. While their 1998 survey did not measure the hours directors
spent on their duties, it does mention that their average compensation has climbed
to $ 37,924. As a result of scandals associated with lack of board oversight at
companies like Enron and Worldcom, directors have come under more pressure to
take their jobs seriously. The Korn-Ferry survey in 2002 noted an increase in
hours worked by the average director to 183 hours a year and a corresponding
surge in compensation.
(2) Even those directors who spend time trying to understand the internal
workings of a firm are stymied by their lack of expertise on many issues,

4Korn-Ferry surveys the boards of large corporations and provides insight into their composition.
5 This understates the true benefits received by the average director in a firm, since it does not count
benefits and perquisites - insurance and pension benefits being the largest component. Hewitt Associates,
an executive search firm, reports that 67% of 100 firms that they surveyed offer retirement plans for their

especially relating to accounting rules and tender offers, and rely instead on
outside experts.
(3) In some firms, a significant percentage of the directors work for the firm, can
be categorized as insiders and are unlikely to challenge the CEO. Even when
directors are outsiders, they are not independent, insofar as the company's Chief
Executive Officer (CEO) often has a major say in who serves on the board. Korn
Ferry's annual survey of boards also found, in 1988, that 74% of the 426
companies it surveyed relied on recommendations by the CEO to come up with
new directors, while only 16% used a search firm. In its 1998 survey, Korn Ferry
did find a shift towards more independence on this issue, with almost three-
quarters of firms reporting the existence of a nominating committee that is, at
least, nominally independent of the CEO. The 2002 survey confirmed a
continuation of this shift.
(4) The CEOs of other companies are the favored choice for directors, leading to
a potential conflict of interest, where CEOs sit on each other™s boards.
(5) Most directors hold only small or token stakes in the equity of their
corporations, making it difficult for them to empathize with the plight of
shareholders, when stock prices go down. In a study in the late 1990s,
Institutional Shareholder Services, a consultant, found that 27 directors at 275 of
the largest corporations in the United States owned no shares at all, and about 5%
of all directors owned fewer than five shares.
The net effect of these factors is that the board of directors often fails at its
assigned role, which is to protect the interests of stockholders. The CEO sets the agenda,
chairs the meeting and controls the information, and the search for consensus generally
overwhelms any attempts at confrontation. While
Greenmail: Greenmail
there is an impetus towards reform, it has to be noted
refers to the purchase of a
that these revolts were sparked not by board
potential hostile acquirer™s stake
members, but by large institutional investors. in a business at a premium over
The failure of the board of directors to protect the price paid for that stake by
the target company.
stockholders can be illustrated with numerous
examples from the United States, but this should not

blind us to a more troubling fact. Stockholders exercise more power over management in
the United States than in any other financial market. If the annual meeting and the board
of directors are, for the most part, ineffective in the United States at exercising control
over management, they are even more powerless in Europe and Asia as institutions that
protect stockholders.

The Consequences of Stockholder Powerlessness
If the two institutions of corporate governance -- annual meetings and the board
of directors -- fail to keep management responsive to stockholders, as argued in the
previous section, we cannot expect managers to maximize stockholder wealth, especially
when their interests conflict with those of stockholders. Consider the following examples.

Golden Parachute: A golden parachute
1. Fighting Hostile Acquisitions
refers to a contractual clause in a management
When a firm is the target of a
contract that allows the manager to be paid a
hostile takeover, managers are sometimes specified sum of money in the event control of
faced with an uncomfortable choice. the firm changes, usually in the context of a
hostile takeover.
Allowing the hostile acquisition to go
through will allow stockholders to reap substantial financial gains but may result in the
managers losing their jobs. Not surprisingly, managers often act to protect their interests,
at the expense of stockholders:
The managers of some firms that were targeted by acquirers (raiders) for hostile

takeovers in the 1980s were able to avoid being acquired by buying out the
raider's existing stake, generally at a price much greater than the price paid by the
raider and by using stockholder cash. This process, called greenmail, usually
causes stock prices to drop but it does protect the jobs of incumbent managers.
The irony of using money that belongs to stockholders to protect them against
receiving a higher price on the stock they own seems to be lost on the
perpetrators of greenmail.
Another widely used anti-takeover device is a golden parachute, a provision in an

employment contract that allow for the payment of a lump-sum or cash flows over
a period, if the manager covered by the contract loses his or her job in a takeover.
While there are economists who have justified the payment of golden parachutes

as a way of reducing the conflict between stockholders and managers, it is still
unseemly that managers should need large side-payments to do that which they
are hired to do-- maximize stockholder wealth.
Firms sometimes create poison pills, which

Poison Pill: A poison pill is a
are triggered by hostile takeovers. The
security or a provision that is triggered by
objective is to make it difficult and costly
the hostile acquisition of the firm, resulting
to acquire control. A flip over rights offer a in a large cost to the acquirer.
simple example. In a flip over right,
existing stockholders get the right to buy shares in the firm at a price well above
the current stock price as long as the existing management runs the firm; this right
is not worth very much. If a hostile acquirer takes over the firm, though,
stockholders are given the right to buy additional shares at a price much lower
than the current stock price. The acquirer, having weighed in this additional cost,
may very well decide against the acquisition.
Greenmail, golden parachutes and poison pills generally do not require stockholder
approval and are usually adopted by compliant boards of directors. In all three cases, it
can be argued, managerial interests are being served at the expenses of stockholder

2. Anti-takeover Amendments:
Anti-takeover amendments have the same objective as greenmail and poison pills,
i.e., dissuading hostile takeovers, but differ on one very important count. They require the
assent of stockholders to be instituted. There are several types of anti-takeover
amendments, all designed with the objective of reducing the likelihood of a hostile
takeover. Consider, for instance, a super-majority amendment; to take over a firm that
adopts this amendment, an acquirer has to acquire more than the 51% that would
normally be required to gain control. Anti-takeover amendments do increase the
bargaining power of managers when negotiating with acquirers and could work to the
benefit of stockholders6, but only if managers act in the best interests of stockholders.

6 As an example, when AT&T tried to acquire NCR in 1991, NCR had a super-majority anti-takeover
amendment. NCR's managers used this requirement to force AT&T to pay a much higher price for NCR

2.2. ˜: Anti-takeover Amendments and Management Trust
If as a stockholder in a company, you were asked to vote on an amendment to the
corporate charter which would restrict hostile takeovers of your company and give your
management more power, in which of the following types of companies would you be
most likely to vote yes to the amendment?
a. Companies where the managers promise to use this power to extract a higher price for
you from hostile bidders
b. Companies which have done badly (in earnings and stock price performance) in the
last few years
c. Companies which have done well (in earnings and stock price performance) in the
last few years
d. I would never vote for such an amendment

Paying too much on acquisitions
There are many ways in which managers can make their stockholders worse off -
by investing in bad projects, by borrowing too much or too little and by adopting
defensive mechanisms against potentially value-increasing takeovers. The quickest and
perhaps the most decisive way to impoverish stockholders is to overpay on a takeover,
since the amounts paid on takeovers tend to dwarf
Synergy: Synergy is the additional value
those involved in the other decisions listed above. Of
created by bringing together two entities,
course, the managers of the firms doing the
and pooling their strengths. In the
acquiring will argue that they overpay on context of a merger, synergy is the
takeovers, and that the high premiums paid in difference between the value of the
acquisitions can be justified using any number of merged firm, and sum of the values of
the firms operating independently.
reasons -- there is synergy, there are strategic
considerations, the target firm is undervalued and badly managed, and so on. The
stockholders in acquiring firms do not seem to share the enthusiasm for mergers and

shares than their initial offer.
7 One explanation given for the phenomenon of overpaying on takeovers is given by Roll, who posits that it
is managerial hubris (pride) that drives the process.

acquisitions that their managers have, since the stock prices of bidding firms decline on
the takeover announcements a significant proportion8 of the time.
These illustrations are not meant to make the case that managers are venal and
selfish, which would be an unfair charge, but are manifestations of a much more
fundamental problem; when there is conflict of interest between stockholders and
managers, stockholder wealth maximization is likely to take second place to management

This data set has the break down of CEO compensation for many U.S. firms for
the most recent year.

Illustration 2.1: Assessing Disney™s Board of Directors
Over the last decade Disney has emerged as a case study of weak corporate


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