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governance, where a powerful CEO, Michael Eisner, has been given free rein by a
captive board of directors. We will look at Disney™s board of directors in 1997, when
Fortune magazine ranked it as having the worst board of the Fortune 500 companies and
again in 2002, when it made the list of the five most improved boards.
At the end of 1996, Disney had 15 members on its board and the board members
are listed in table 2.1, categorized by whether they work or worked for Disney (insiders)
or not (outsiders).
Table 2.1: Disney™s Board of Directors “ 1996
Insiders Outsiders
Michael D. Eisner, 54: CEO Reveta F. Bowers, 48: Head of school for
Roy E. Disney, 66: Head of animation the Center for Early Education, where Mr.
department. Eisner's children attended class.
Sanford M. Litvack, 60: Chief of corporate Ignacio E. Lozano Jr., 69: Chairman of
operations. Lozano Enterprises, publisher of La
Richard A. Nunis, 64: Chairman of Walt Opinion newspaper in Los Angeles.

8 Jarrell, Brickley and Netter (1988) in an extensive study of returns to bidder firms note that excess returns
on these firms' stocks around the announcement of takeovers have declined from an average of 4.95% in
the sixties to 2% in the seventies to -1% in the eighties. You, Caves, Smith and Henry (1986) examine 133
mergers between 1976 and 1984 and find that the stock prices of bidding firms declined in 53% of the

Disney Attractions. George J. Mitchell, 63: Washington, D.C.
*Raymond L. Watson, 70: Disney attorney, former U.S. senator. Disney paid
chairman in 1983 and 1984. Mr. Mitchell $50,000 for his consulting on
*E. Cardon Walker, 80: Disney chairman international business matters in 1996. His
and chief executive, 1980-83 Washington law firm was paid an
*Gary L. Wilson, 56: Disney Chief additional $122,764.
Financial Officer, 1985-89 Stanley P. Gold, 54: President and chief
* Thomas S. Murphy, 71: Former chairman executive of Shamrock Holdings Inc.,
and chief executive of Capital Cities/ABC which manages about $1 billion in
Inc. investments for the Disney family.
The Rev. Leo J. O'Donovan, 62: President
* Ex-officials of Disney of Georgetown University, where one of
Mr.Eisner's children attended college. Mr.
Eisner sat on Georgetown board and has
contributed more than $1 million to the
Irwin E. Russell, 70: Beverly Hills, Calif.,
attorney whose clients include Mr. Eisner.
* Sidney Poitier, 69: Actor.
Robert A.M. Stern, 57: New York architect
who has designed numerous Disney
projects. He received $168,278 for those
services in fiscal 1996.

Note that eight of the sixteen members on the board are or were Disney employees and
that Michael Eisner, in addition to being CEO, chaired the board. Of the eight outsiders,
at least five had potential conflicts of interests because of their ties with either Disney or
Michael Eisner. The potential conflicts are listed in italics in table 2.1. Given the
composition of this board, it should come as no surprise that it failed to assert its power
against incumbent management.9
In 1997, Calpers, the California public employee pension fund, suggested a series
of checks to see if a board was likely to be effective in acting as a counter-weight to a
powerful CEO including:
Are a majority of the directors outside directors?

9 One case where it cost Disney dearly was when Mr. Eisner prevailed on the board to hire Michael Ovitz,
a noted Hollywood agent, with a generous compensation. A few years later, Ovitz left the company after
falling out with Eisner, creating a multi-million liability for Disney. A 2003 lawsuit against Disney™s board
members in 1996 contended that they failed in their fiduciary duty by not checking the terms of the
compensation agreement before assenting to the hiring.

Is the chairman of the board independent of the company (and not the CEO of the

Are the compensation and audit committees composed entirely of outsiders?

When Calpers put the companies in the S&P 500 through these tests in 1997, Disney was
the only company that failed all of the tests, with insiders on every one of the key
Disney came under pressure from stockholders to modify its corporate
governance practices between 1997 and 2002 and did make some changes to its board.
Table 2.2 lists the board members in 2002.
Table 2.2: Disney™s Board of Directors “ 2002
Board Members Occupation
Reveta Bowers Head of school for the Center for Early Education,
John Bryson CEO and Chairman of Con Edison
Roy Disney Head of Disney Animation
Michael Eisner CEO of Disney
Judith Estrin CEO of Packet Design (an internet company)
Stanley Gold CEO of Shamrock Holdings
Robert Iger Chief Operating Officer, Disney
Monica Lozano Chief Operation Officer, La Opinion (Spanish newspaper)
George Mitchell Chairman of law firm (Verner, Liipfert, et al.)
Thomas S. Murphy Ex-CEO, Capital Cities ABC
Leo O™Donovan Professor of Theology, Georgetown University
Sidney Poitier Actor, Writer and Director
Robert A.M. Stern Senior Partner of Robert A.M. Stern Architects of New York
Andrea L. Van de Kamp Chairman of Sotheby's West Coast
Raymond L. Watson Chairman of Irvine Company (a real estate corporation)
Gary L. Wilson Chairman of the board, Northwest Airlines.

Note that many of the board members with conflicts of interests from 1996 continue to
serve on the board. On a positive note, the number of insiders on the board has dropped
from eight to six but the board size remains sixteen members. In summary, while the
board itself may be marginally more independent in 2002 than it was in 1997, it is still far
from ideal in its composition.

Illustration 2.2: Corporate Governance at Aracruz: Voting and Non-voting Shares
Aracruz Cellulose, like most Brazilian companies, had multiple classes of shares
at the end of 2002. The common shares had all of the voting rights and were held by

incumbent management, lenders to the company and the Brazilian government. Outside
investors held the non-voting shares, which were called preferred shares10, and had no
say in the election of the board of directors. At the end of 2002, Aracruz was managed by
a board of seven directors, composed primarily of representatives of those who own the
common (voting) shares, and an executive board, composed of three managers of the
Without analyzing the composition of the board of Aracruz, it is quite clear that
there is the potential for a conflict of interest between voting shareholders who are fully
represented on the board and preferred stockholders who are not. While Brazilian law
provides some protection for the latter, preferred stockholders have no power to change
the existing management of the company and little influence over major decisions that
can affect their value.

Illustration 2.3: Corporate Governance at Deutsche Bank: Cross Holdings
Deutsche Bank follows the German tradition and legal requirement of having two
boards. The board of managing directors, which is composed primarily of incumbent
managers, develops the company™s strategy, reviews it with the Supervisory Board and
ensures its implementation. The Supervisory Board appoints and recalls the members of
the Board of Managing Directors and, in cooperation with the Board of Managing
Directors, arranges for long-term successor planning. It also advises the board of
Managing Directors on the management of business and supervises it in its achievement
of long-term goals.
A look at the supervisory board of directors at Deutsche provides some insight
into the differences between the US and German corporate governance systems. The
supervisory board at Deutsche Bank consists of twenty members, but eight are
representatives of the employees. While the remaining twelve are elected by
shareholders, employees clearly have a much bigger say in how companies are run in
Germany and can sometimes exercise veto power over company decisions. Deutsche
Bank™s corporate governance structure is also muddied by cross holdings. Deutsche is the

10 This can create some confusion for investors in the United States, where preferred stock is stock with a
fixed dividend and resembles bonds more than conventional common stock.

largest stockholder in Daimler Chrysler, the German automobile company, and Allianz,
the German insurance company, is the largest stockholder in Deutsche.

In Practice: Is there a payoff to better corporate governance?
While academics and activist investors are understandably enthused by moves
towards giving stockholders more power over managers, a practical question that is often
not answered is what the payoff to better corporate governance is. Are companies where
stockholders have more power over managers managed better and run more efficiently?
If so, are they more valuable? While no individual study can answer these significant
questions, there are a number of different strands of research that offer some insight:
In the most comprehensive study of the effect of corporate governance on value, a

governance index was created for each of 1500 firms based upon 24 distinct
corporate governance provisions.11 Buying stocks that had the strongest investor
protections while simultaneously selling shares with the weakest protections
generated an annual excess return of 8.5%. Every one point increase in the index
towards fewer investor protections decreased market value by 8.9% in 1999 and
firms that scored high in investor protections also had higher profits, higher sales
growth and made fewer acquisitions. These findings are echoed in studies on
firms in Korea12 and Germany13.
Actions that restrict hostile takeovers generally reduce stockholder power by

taking away one of the most potent weapons available against indifferent
management. In 1990, Pennsylvania considered passing a state law that would
have protected incumbent managers against hostile takeovers by allowing them to
override stockholder interests if other stakeholders were adversely impacted. In

11Gompers, P.A., J.L. Ishii and A. Metrick, 2003, Corporate Governance and Equity Prices, Quarterly
Journal of Economics, v118, 107-155. The data for the governance index was obtained from the Investor
Responsibility Research Center which tracks the corporate charter provisions for hundreds of firms.
12 Black, B.S., H. Jang and W. Kim, 2003, Does Corporate Governance affect Firm Value? Evidence from
Korea, Stanford Law School Working Paper.
13 Drobetz, W., 2003, Corporate Governance: Legal Fiction or Economic Reality, Working Paper,
University of Basel.

the months between the time the law was first proposed and the time it was
passed, the stock prices of Pennsylvania companies declined by 6.90%.14
There seems to be little evidence of a link between the composition of the board

of directors and firm value. In other words, there is little to indicate that
companies with boards that have fewer insiders trade at higher prices than
companies with insider dominated boards. 15
While this is anecdotal evidence, the wave of corporate scandals “ Enron,

Worldcom and Tyco - in the United States 2000 and 2001 indicated a significant
cost to having a compliant board. A common theme that emerged at problem
companies was an ineffective board that failed to ask tough questions of an
imperial CEO,

Stockholders and Bondholders
In a world where what is good for stockholders in a firm is also good for its
bondholders (lenders), the latter might not have to worry about protecting themselves
from expropriation. In the real world, however, there is a risk that bondholders, who do
not protect themselves, may be taken advantage of in a variety of ways - by stockholders
borrowing more money, paying more dividends or undercutting the security of the assets
on which the loans were based.

The Source of the Conflict
The source of the conflict of interest between stockholders and bondholders lies in
the differences in the nature of the cash flow claims of the two groups. Bondholders
generally have first claim on cash flows, but receive fixed interest payments, assuming
that the firm makes enough income to meet its debt obligations. Equity investors have a
claim on the cashflows that are left over, but have the option in publicly traded firms of
declaring bankruptcy if the firm has insufficient cash flows to meet its financial

14 Karpoff, J.M. and P.H. Malatesta, 1990, The Wealth Effects of Second-Generation State Takeover
Legislation, Journal of Financial Economics, v25, 291-322.
15 Bhagat, Sanjai & Bernard Black. 1999. The Uncertain Relationship Between Board Composition and
Firm Performance. Business Lawyer. v54, 921-963.

obligations. Bondholders do not get to participate on the upside if the projects succeed,
but bear a significant portion of the cost, if they fail. As a consequence, bondholders tend
to view the risk in investments much more negatively than stockholders. There are many
issues on which stockholders and bondholders are likely to disagree.

Some Examples of the Conflict
Existing bondholders can be made worse off by increases in borrowing, especially
if these increases are large and affect the default risk of the firm, and these bondholders
are unprotected. The stockholders' wealth increases concurrently. This effect is
dramatically illustrated in the case of acquisitions funded primarily with debt, where the
debt ratio increases and the bond rating drops significantly. The prices of existing bonds
fall to reflect the higher default risk.16
Dividend policy is another issue on which a conflict of interest may arise between
stockholders and bondholders. The effect of higher dividends on stock prices can be
debated in theory, with differences of opinion on whether it should increase or decrease
prices, but the empirical evidence is clear. Increases in dividends, on average, lead to
higher stock prices, while decreases in dividends lead to lower stock prices. Bond prices,
on the other hand, react negatively to dividend increases and positively to dividend cuts.
The reason is simple. Dividend payments reduce the cash available to a firm, thus making
debt more risky.

The Consequences of Stockholder-Bondholder Conflicts
As these two illustrations make clear,
Bond Covenants: Covenants are restrictions built
stockholders and bondholders have different into contractual agreements. The most commom
objectives and some decisions can transfer reference in corporate finance to covenants is in
wealth from one group (usually bondholders) to bond agreements, and they represent restrictions
placed by lenders on investment, financing and
the other (usually stockholders). Focusing on
dividend decisions made by the firm.
maximizing stockholder wealth may result in
stockholders taking perverse actions that harm

16 In the leveraged buyout of Nabisco, existing bonds dropped in price 19% on the day of the acquisition,
even as stock prices zoomed up.

the overall firm, but increase their wealth at the expense of bondholders.
It is possible that we are making too much of the expropriation possibility, for a
couple of reasons. Bondholders are aware of the potential of stockholders to take actions
that are inimical to their interests, and generally protect themselves, either by writing in
covenants or restrictions on what stockholders can do, or by taking an equity interest in
the firm. Furthermore, the need to return to the bond markets to raise further funds in the


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