Corporate Governance When Managers Set Their Own Pay

This paper presents a model of the firm in which the manager has discretion over his own compensation, constrained only by the threat of shareholder intervention. The model addresses two main questions. How does shareholder power affect managers' compensation and their incentives to maximise firm value? And what is the optimal level of shareholder power? Expectedly, the model shows that increasing shareholder power leads to lower managerial pay. Greater shareholder power, however, also weakens the manager's incentives to maximise value and may even lead to lower profits for shareholders. There might, thus, be too much, as well as too little, shareholder power. The model characterises the optimal level of shareholder power and yields predictions about the relation between shareholder power, managerial pay, performance and firm characteristics.     

Informed traders and limit order markets

We consider a dynamic limit order market in which traders optimally choose whether to acquire information about the asset and the type of order to submit. We numerically solve for the equilibrium and demonstrate that the market is a “volatility multiplier”: prices are more volatile than the fundamental value of the asset. This effect increases when the fundamental value has high volatility and with asymmetric information across traders. Changes in the microstructure noise are negatively correlated with changes in the estimated fundamental value, implying that asset betas estimated from high-frequency data will be incorrect.     

Public Trading and Private Incentives

This article studies the link between public trading and theactivity of a firm's large shareholder who can affect firm value.Public trading results in the formation of a stock price thatis informative about the large shareholder's activity. Thisincreases the latter's incentives to engage in value-increasingactivities. Indeed, if he has to liquidate part of his stakebefore the effect of his activity is publicly observed, a moreinformative price rewards him for his activity. Implicationsare derived for the decision to go public, capital structure,and security design.     

Fundamental Investors Reduce the Distraction on Management from Random Market “Noise”: Evidence from France

The authors find that financial markets have real effects on corporate decisions but that, unfortunately, some temporary market enthusiasm, unrelated to firm intrinsic value, may cause management to make value‐destroying decisions as the result of random and uninformed stock market volatility. In particular, they are prone to making bad decisions after stock market overreactions to “surprise” earnings announcements. This study shows a positive effect of greater long‐term ownership on French listed firms. Fundamental investor ownership reduces the degree of market mispricing which serves long‐run shareholder value maximization. A fundamental investor is one that, on average, hold his shares for at least two years, is in the top quartile of a firm ownership, and has an active allocation strategy. They are about 8% of all investors. Compared to non‐fundamental investors, fundamental investors hold their positions on average three times longer and have positions 1.5 times larger. Fundamental investors are more present in firms which have more liquid stocks, which pay dividends, and which are relatively poorer performers and have relatively lower market‐to‐book than their industry peers.     

Controlling shareholders and market timing in share issuance

We examine market timing in the equity issuance of firms controlled by large shareholders using a hand-collected data set of controlling shareholders' ownership stakes in Chile between 1990 and 2009. When a firm issues shares, the controlling shareholder can either maintain or change his ownership stake depending on how many of the new shares he subscribes. Issuance predicts poor future returns and is preceded by high returns, but only when the controlling shareholder's stake is significantly reduced. Consistent with market timing, the results are stronger in the absence of institutional investors and in hot issuance markets.     

Arbitrage Chains

A privately informed trader will engage in costly arbitrage, that is, trade on his knowledge that the price of an asset is different from the fundamental value if: (1) his order does not move the price immediately to reflect the information; and (2) he can hold the asset until the date when the information is reflected in the price. We study a general equilibrium model in which all agents optimize. In each period, there may be a trader with a limited horizon who has private information about a distant event. Whether he acts on his information, and whether subsequent informed traders act, is shown to depend on the possibility of a sequence or chain of future informed traders spanning the event date. An arbitrageur who receives good news will buy only if it is likely that, at the end of his trading horizon, a subsequent arbitrageur's buying will have pushed up the expected price. We show that limited trading horizons result in inefficient prices, because informed traders do not act on their information until the event date is sufficiently close. We also show that limited horizons can arise because of the cost-carry associated with holding an arbitrage portfolio over an extended period of time.     

Classified boards,firm value,and managerial entrenchment

This paper shows that classified boards destroy value by entrenching management and reducing director effectiveness. First, I show that classified boards are associated with a significant reduction in firm value and that this holds even among complex firms, although such firms are often regarded as most likely to benefit from staggered board elections. I then examine how classified boards entrench management by focusing on CEO turnover, executive compensation, proxy contests, and shareholder proposals. My results indicate that classified boards significantly insulate management from market discipline, thus suggesting that the observed reduction in value is due to managerial entrenchment and diminished board accountability.     

The role of a large trader in a dynamic currency attack model

This paper studies the role of a large trader in a dynamic currency attack model based on Abreu and Brunnermeier (2003), who study stock market bubbles and crashes in a dynamic model with a continuum of rational small traders. We introduce a large trader into their model and apply it to currency attacks. In an attack against a fixed exchange rate regime with a gradually overvalued currency, traders lack common knowledge about the time when the overvaluation starts and need to coordinate to break a peg. Both the inability of traders to synchronize their attack and their incentive to time the collapse of the regime lead to the persistent overvaluation of the currency. We find that the presence of a large trader with perfect information induces small traders to attack sooner and leads to an accelerated collapse of the regime. But the presence of a large trader with noisy information may delay the collapse of the regime ex post. Moreover, a large trader with precise information tends to be at the rear of an attack. With noisy information, he could attack earlier or later than small traders. In both cases, the large trader affects market dynamics of the attack substantially.     

Book Value,Residual Earnings,and Equilibrium Firm Value with Asymmetric Information

The residual income valuation model (RIM) by Ohlson (1995) and Feltham and Ohlson (1995) assumes that investors are risk-neutral with homogenous beliefs. Thus, the present value of expected dividends represents firm value. The purpose of the present study is to derive a RIM in a market setting of the Kyle (1985) type. Since traders are asymmetrically informed in the Kyle setting, firm value is no longer equivalent to the present value of the firm's expected dividends. In the present model, the informed investor observes a signal about the firm's profitability, which the market maker (who sets the price) is unable to observe. The market maker infers the informed investor's private signal based on the total order flow, which is an informative but noisy signal. The analysis identifies the equilibrium firm value as a linear function of current book value, current residual income, and the aggregate order flow.     

Earnings Metrics,Information Processing,and Price Efficiency in Laboratory Markets

An enduring issue in financial reporting is whether and how salient summary measures of firm performance (“earnings metrics”) affect market price efficiency. In laboratory markets, we test the effects of salient earnings metrics, which vary in how they combine persistent and transitory elements, on investor information search, beliefs about value, offers to trade, and market price efficiency. We find that including transitory elements in salient earnings metrics causes traders to search unnecessarily for further information about these elements and to overestimate their effect on fundamental value relative to a rational benchmark. In contrast, separately displaying persistent elements in earnings increases the accuracy of traders’ value estimates. Prices generally reflect traders’ beliefs about value, and prices are most efficient when transitory elements are excluded from earnings metrics entirely. Our study contributes to research on salience effects in financial reporting by showing that including transitory elements in salient earnings metrics causes inefficient information search and biased beliefs about value that can aggregate to affect market prices. We also contribute to research in experimental markets by showing that redundant disclosure is not always beneficial; redundant disclosure of transitory earnings elements, in particular, appears to have negative consequences for investor behavior and market efficiency.     

The Cost of Multiple Large Shareholders

Previous research argues that large noncontrolling shareholders enhance firm value because they deter expropriation by the controlling shareholder. We propose that the conflicting incentives faced by large shareholders may induce a nonlinear relationship between the relative size of large shareholdings and firm value. Consistent with this prediction, we present evidence that there are costs to having a second (and third) largest shareholder, especially when the largest shareholdings are similar in size. Our results are robust to various relative size proxies, firm performance measures, model specifications, and potential endogeneity issues.     

An intertemporal capital asset pricing model with heterogeneous expectations

This paper extends the intertemporal capital asset pricing model (ICAPM) to integrate the heterogeneous trading behavior of three groups of investors; rational utility maximizers, positive feedback, or momentum, traders, and fundamental traders. Using several contemporary fundamental factors to proxy for the latter of these investors’ trading patterns, the interaction of these three groups of investors is explored in the G-7 markets using monthly stock market prices. There is no evidence that positive feedback traders are present in the sample data. Fundamental traders are however observable. This finding suggests that although positive feedback traders may drive stock prices in the short-run, as is typically observed in higher frequency data, fundamental traders likely play a role in pushing prices back to their fundamental value in the longer-run.     

The specialist's discretion: stopped orders and price improvement

When a market order arrives, the NYSE specialist can offer aprice one tick better than the limit orders on the book andtrade for his own account. Alternatively, the specialist can'stop' the market order, which means he guarantees executionat the current quote but provides the possibility of price improvement.My model shows that specialists can use stops to sample thefuture order flow before making a commitment to trade. I presentempirical evidence that both stops and immediate price improvementimpose adverse selection costs on limit order traders.     

Firm size,information acquisition and price efficiency

We present a model in a competitive market where traders choose between a small and a large firm to acquire costly private information, but they also obtain free public information by observing equilibrium share prices. Our major finding is the existence of a noisy rational expectation competitive equilibrium, in which there are more informed traders of the large firm than those of the small firm. As a result, share prices of the large firm are more informative than those of the small firm. Our empirical study supports the analytical results. By using a bivariate vector autoregressive regression, we are able to conduct a variance decomposition of share prices for different size portfolios. We find that prices of large-size portfolios are more informative because non-value-related price shocks are less important in driving price changes of large-size portfolios than in the case of small-size portfolios.     

Convex costs and the hedging paradox

Financial theory suggests that hedging can increase shareholder value in the presence of capital market imperfections, including direct and indirect costs of financial distress, costly external financing, and convex tax exposure. The influence of these costs, which are high when profits are low and low or negligible when profits are large, on the extent of firm hedging has not been consistently addressed in the finance literature. In Brown and Toft's (2002) model, more convex costs imply that a firm will decrease the extent of hedging. At the same time, one version of Smith and Stulz's (1985) tax hypothesis implies that a given firm is expected to increase the extent of hedging under a more convex tax exposure. I address this ambiguity in the literature by showing that, in incomplete markets, value-maximizing firms that stand to gain the most from hedging may in fact hedge less than otherwise identical firms with less to gain from hedging. This hedging paradox can partly account for the lack of conclusive evidence to suggest that convex costs can influence both a firm's decision to hedge and the extent of the firm's hedging. Finally, I introduce a new interpretation of empirical relations between potential hedging gains and the extent of hedging.     

Does “Vote No” Change Corporate Governance and Firm Value? Evidence from the Shareholder Activism of the Korean National Pension Service

In this paper, we analyze the effect of shareholder activism on firm value through internal corporate governance in an emerging market. We investigate the shareholder activism by the National Pension Service (NPS) of Korea, the fourth-largest pension fund in the world in 2010. We investigate stock price reaction to a “vote no” press announcement and find that the market does not react in the short run, which reaction is inconsistent with the results from developed countries. We also find that firms experiencing “vote no” and improved internal corporate governance have higher firm valuation. Shareholder activism by the NPS is effective in increasing target firm value through improving internal corporate governance.     

Estimating the expropriation of minority shareholders: Results from a new empirical approach

Abstract

A novel methodological approach is proposed to estimate the effect of separation of ownership and control by dominant shareholders on firm value. The approach offers two major innovations. First, it frees the researcher from the necessity of having to make an ad hoc judgment call regarding which firms feature entrenched owners and which don’t. Under this approach, the main shareholder becomes entrenched when the Shapley Value (SV) of his voting rights crosses an unknown threshold that is estimated jointly with the other model parameters. This approach allows one to perform a test on the joint hypotheses that the incentive to expropriate held by the dominant shareholder impacts negatively the market performance of the firm if the main shareholder is entrenched but produces no impact otherwise. Secondly, it generates a market-based estimate of the critical level of power at which the main shareholder becomes entrenched. The method is applied to a sample of European firms and a threshold equal to 0.34 is estimated. Most firms from the UK have a main shareholder with a SV below the estimated threshold; in contrast, about half of the continental firms in the sample feature main shareholders whose power index is above the estimated threshold. A negative relationship is found between the incentive to expropriate and corporate valuation above the threshold, that is both statistically and economically significant; below the threshold, we find no evidence of a relationship.     

Information Sales and Insider Trading with Long-Lived Information

Fundamental information resembles in many respects a durable good. Hence, the effects of its incorporation into stock prices depend on who is the agent controlling its flow. Like a durable goods monopolist, a monopolistic analyst selling information intertemporally competes against herself. This forces her to partially relinquish control over the information flow to traders. Conversely, an insider solves the intertemporal competition problem through vertical integration, thus exerting tighter control over the information flow. Comparing market patterns I show that a dynamic market where information is provided by an analyst is thicker and more informative than one where an insider trades.     

The determinants of shareholder value in European banking

This paper examines the determinants of shareholder value creation for a large sample of European banks between 1998 and 2005. As the recent turmoil in global banking systems has illustrated, bank performance can have a substantial influence on efficient capital allocation, company growth and economic development. We use a dynamic panel data model where the bank’s shareholder value is a linear function of various bank-specific, industry-specific and macroeconomic variables. We show that shareholder value has a positive relationship with cost efficiency changes, while economic profits are linked to revenue efficiency changes. Credit losses, market and liquidity risk and leverage are also found to substantially influence bank performance. These results are robust to a variety of different model specifications.     

Shareholder activism and voluntary disclosure

We examine the relation between shareholder activism and voluntary disclosure. An important consequence of voluntary disclosure is less adverse selection in the capital markets. One class of traders that finds less adverse selection unprofitable is activist investors who target mispriced firms whose valuations they can improve. Consistent with this idea, we find that managers issue earnings and sales forecasts more frequently when their firm is more at risk of attack by activist investors, and that these additional disclosures reduce the likelihood of becoming an activist’s target. These additional disclosures also prompt a positive price reaction, contain more precise guidance, and exceed prevailing market expectations. These findings imply that managers use voluntary disclosure to preempt activism at their firm, and that activists prefer to target relatively opaque firms.