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Stockholders and Managers
There are clearly conflicts of interests between stockholders and managers, and
the traditional mechanisms for stockholder control -- annual meetings and boards of
directors -- often fail at their role of discipline management. This does not mean,
however, that the chasm between the two groups is too wide to be bridged, either by
closing the gap between their interests or by increasing stockholder power over

Making managers think more like stockholders
As long as managers have interests that are distinct and different from the
interests of the stockholders they serve, there is potential for conflict. One way to reduce
this conflict is to provide managers with an equity stake in the firms they manage, either

by providing them with stock or warrants on the stock. If this is done, the benefits that
accrue to management from higher stock prices
Warrants: A warrant is a security
may provide an inducement to maximize stock issued by a company that provides the holder
prices. with the right to buy a share of stock in the
There is a downside to doing this, which company at a fixed price during the life of
the warrant.
is that while it reduces the conflict of interest
between stockholders and managers, it may exacerbate the other conflicts of interest
highlighted in the prior section. It may increase the potential for expropriation of wealth
from bondholders and the probability that misleading information may be conveyed to
financial markets.
There is a final distinction that we need to make between stock based
compensation and warrant based compensation. As we will see in the coming chapters,
options can sometimes become more valuable as you increase the risk in a business.
Consequently, managers who have substantial option holdings and little in common stock
may be tempted to take on far more risk than would be desired by other shareholders in
the firm.

2.7. ˜: Stockholder Interests, Managerial Interests and Management Buyouts
In a management buyout, the managers of the firm buy out the existing stockholders and
make the company a private firm. Is this a way of reducing the conflict of interests
between stockholders and managers?
a. Yes
b. No

More Effective Boards of Directors
In the last few years, there have been encouraging trends both in the composition
and the behavior of boards, making them more effective advocates for stockholders. Korn
Ferry™s survey of boards of directors at 900 large US corporations in 1998 revealed the

Boards have become smaller over time. The median size of a board of directors has

decreased from 16 to 20 in the 1970s to between 9 and 11 in 1998. The smaller
boards are less unwieldy and more effective than the larger boards.
There are fewer insiders on the board. In contrast to the 6 or more insiders that many

boards had in the 1970s, only two directors in most boards in 1998 were insiders.
Directors are increasingly compensated with stock and options in the company,

instead of cash. In 1973, only 4% of directors received compensation in the form of
stock or options, whereas 78% did so in 1998. This stock compensation makes it
more likely that directors will think like stockholders.
More directors are identified and selected by a nominating committee rather than

being chosen by the CEO of the firm. In 1998, 75% of boards had nominating
committees; the comparable statistic in 1973 was 2%.
Is there a payoff to a more active board? MacAvoy and Millstein (1998) present evidence
that companies with more activist boards, where activism was measured based both up
assessments by CALPERS and indicators of board behavior, earned much higher returns
on their capital than firms that had less active boards.

Increasing stockholder power
There are many ways in which stockholder power over management can be
increased. The first is to provide stockholders with better and more updated information,
so that they can make better judgments on how well the management is doing. The
second is to have a large stockholder become part of incumbent management, and have a
direct role in decisions that the firm makes. The third is to have more 'activist'
institutional stockholders, who play a larger role in issues such as the composition of the
board of directors, the question of whether to pass anti-takeover amendments and overall
management policy. In recent years, some institutional investors have used their
considerable power to pressure managers into becoming more responsive to their needs.
Among the most aggressive of these investors has been the California Public Employees
Retirement System (CALPERS), one of the largest institutional investors in the country.
Unfortunately, the largest institutional investors “ mutual funds and pension fund
companies “ have remained largely apathetic. The fourth change, pushed by these activist

stockholders, is to make boards of directors more responsive to stockholders, by reducing
the number of insiders on these boards and making them more independent of CEOs.
It is also critical that institutional constraints on stockholders exercising their
power be reduced. All common shares should have the same voting rights and state
restrictions on takeovers have to be eliminated and shareholder voting should be
simplified. The legal system should come down hard on managers (and boards of
directors) who fail to do their fiduciary duty. Ultimately, though, stockholders have to
awake to the reality that the responsibility for monitoring management falls to them. Like
voters in a democracy, shareholders get the managers they deserve.

2.8. ˜: Inside Stockholders versus Outside Stockholders
There are companies like Microsoft where a large stockholder (Bill Gates) may be the on
the inside as the manager of the concern. Is it possible that what is in Bill Gates™ best
interests as an “inside” stockholder may not be in the interests of a stockholder on the
a. Yes. Their interests may deviate.
b. No. Their interests will not deviate
If yes, provide an example of an action that may benefit the inside stockholder but not the
outside stockholder.

The Threat of a Takeover
The perceived excesses of many takeovers in the eighties drew attention to the
damage created to employees and society some of them. In movies and books, the raiders
who were involved in these takeovers were portrayed as 'barbarians', while the firms
being taken over were viewed as hapless victims. While this may have been true in some
cases, the reality was that in most cases, companies that were taken over deserved to be
taken over. One analysis found that target firms in hostile takeovers in 1985 and 1986
were generally much less profitable than their competitors, had provided sub-par returns
to their stockholders and that managers in these firms had significantly lower holdings of

the equity. In short, badly managed firms were much more likely to become targets of
hostile takeover bids.30
An implication of this finding is that takeovers operate as a disciplinary
mechanism, keeping managers in check, by introducing a cost to bad management. Often,
the very threat of a takeover is sufficient to make firms restructure their assets and
become more responsive to stockholder concerns. It is not surprising, therefore, that legal
attempts to regulate and restrict takeovers have had negative consequences for stock

2.9. ˜: Hostile Acquisitions: Who do they hurt?
Given the information presented in this chapter, which of the following groups is
likely to be the most likely to be protected by a law banning hostile takeovers?
a. Stockholders of target companies
b. Managers and employees of well-run target companies
c. Managers and employees of badly-run target companies
d. Society

Illustration 2.6: Restive Stockholders and Responsive Managers: The Disney Case
In 1997, Disney was widely perceived as having an imperial CEO in Michael
Eisner and a captive board of directors. After a series of missteps including the hiring and
firing of Michael Ovitz and bloated pay packages, Disney stockholders were restive but
there were no signs of an impending revolt at that time. As Disney™s stock price slid
between 1997 and 2000, though, this changed as more institutional investors made their
displeasure with the state of corporate governance at the company. As talk of hostile
takeovers and proxy fights filled the air, Disney was forced to respond. In its 2002 annual
report, Disney listed the following corporate governance changes:
Required at least two executive sessions of the board, without the CEO or other

members of management present, each year.

30 Bhide, A., 1989, The Causes and Consequences of Hostile Takeovers, Journal of Applied Corporate
Finance, v2, 36-59.

Created the position of non-management presiding director, and appointed

Senator George Mitchell to lead those executive sessions and assist in setting the
work agenda of the board.
Adopted a new and more rigorous definition of director independence.

Required that a substantial majority of the board be comprised of directors

meeting the new independence standards.
Provided for a reduction in committee size and the rotation of committee and

chairmanship assignments among independent directors.
Added new provisions for management succession planning and evaluations of

both management and board performance
Provided for enhanced continuing education and training for board members.

What changed between 1997 and 2002? While we can point to an overall shift in the
market towards stronger corporate governance, the biggest factor was poor stock price
performance. The truth is that stockholders are often willing to overlook poor corporate
governance and dictatorial CEOs if stock prices are going up but are less tolerant when
stock prices decrease.
Towards the end of 2003, Roy Disney and Stanley Gold resigned from Disney™s
board of directors, complaining both about the failures of Michael Eisner and his
autocratic style.31 When the board of directors announced early in 2004 that Michael
Eisner would receive a $6.25 million bonus for his performance in 2003, some
institutional investors voiced their opposition. Soon after, Comcast announced a hostile
acquisition bid for Disney. At Disney™s annual meeting in February 2004, Disney and
Gold raised their concerns about Eisner™s management style and the still-captive board of
directors and 43% of the stockholders voted against Eisner as director at the meeting. In
a sense, the stars were lining up for the perfect corporate governance storm at Disney,
with Eisner in the eye of the storm. Soon after the meeting, Disney announced that Eisner
would step down as chairman of the board even though he would continue as CEO until
his term expired in 2006.

31 You can read Roy Disney™s letter of resignation on the web site for the book.

In Practice: Proxy Fights
In the section on annual meetings, we pointed out that many investors who are
unable to come to annual meetings also fail to return their proxies, thus implicitly giving
incumbent managers their votes. In a proxy fight, activist investors who want to
challenge incumbent managers approach individual stockholders in the company and
solicit their proxies, which they then can use in votes against the management slate.
In one very public and expensive proxy fight in 2002, David Hewlett, who was
sitting on the board of Hewlett Packard (HP) at the time, tried to stop HP from buying
Compaq by soliciting proxies from HP stockholders. After eight months of acrimony, HP
finally won the fight with the bare minimum 51% of the votes. How did Hewlett come so
close to stopping the deal? One advantage he had was that the Hewlett and Packard
families owned a combined 18% of the total number of shares outstanding. The other was
that Hewlett™s position on the board and his access to internal information gave him a
great deal of credibility when it came to fighting for the votes of institutional investors.
The fact that he failed, even with these advantages, shows how difficult it is to win at a
proxy fight. Even a failed proxy fight, though, often has the salutary effect of awakening
incumbent managers to the need to at least consider what shareholders want.

Stockholders and Bondholders
The conflict of interests between stockholders and bondholders can lead to actions
that transfer wealth to the former from the latter. There are ways in which bondholders
can obtain at least partial protection against some of these actions.

The Effect of Covenants
The most direct way for bondholders to protect themselves is to write in
covenants in their bond agreements specifically prohibiting or restricting actions that may
be wealth expropriating. Many bond (and bank loan) agreements have covenants that do
the following:
(1) Restrict the firm's investment policy: Investing in riskier projects than
anticipated can lead to a transfer of wealth from bondholders to stockholders.
Some bond agreements put restrictions on where firms can invest and how much

risk they can take on in their new investments, specifically to provide bondholders
with the power to veto actions that are not in their best interests.
(2) Restrict dividend policy: In general, increases in dividends increase stock
prices while decreasing bond prices, because they reduce the cash available to the
firm to meet debt payments. Many bond agreements restrict dividend policy, by
tying dividend payments to earnings.
(3) Restrict additional leverage: Some bond agreements require firms to get the
consent of existing lenders before borrowing more money. This is done to protect
the interests of existing secured bondholders.
While covenants can be effective at protecting bondholders against some abuses, they do
come with a price tag. In particular, firms may find themselves having to turn down
profitable investments because of bondholder-imposed constraints and having to pay
(indirectly) for the legal and monitoring costs associated with the constraints.

Taking an Equity Stake
Since the primary reason for the conflict of interests between stockholders and
bondholders lies in the nature of their claims, another way that bondholders can reduce
the conflict of interest is by owning an equity stake in the firm. This can take the form of
buying stock in the firm at the same time as bonds, or it can be accomplished by making
bonds convertible into stock at the option of the bondholders. In either case, bondholders
who feel that equity investors are enriching themselves at the lenders™ expense, can
become stockholders and share in the spoils.

Bond Innovations
In the aftermath of several bond market debacles in the late 1980s, bondholders
became increasingly creative in protecting themselves with new types of bonds. While
we will consider these innovations in more detail later in this book, consider the example
of puttable bonds. Unlike a conventional bond, where you are constrained to hold the
bond to maturity, the holders of a puttable bond can put the bond back to the issuing
company and get the face value of the bond if the company violates the conditions of the
bond. For instance, a sudden increase in borrowing or a drop in bond ratings can trigger
this action.

Firms and Financial Markets


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