EF4313 Corporate Finance

Department of Economics & Finance

City University of HK

Wayne Yu

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 Group Homework
• Group size: 3 to 5 students
• Collectively choose as many listed companies as
the number of group members (e.g., A group of 3
should choose 3 listed companies)
• Focus on companies listed on major stock
exchanges:
• New York Stock Exchange and the NASDAQ
• Hong Kong Stock Exchange
• Shanghai and Shenzhen Stock Exchanges
• London Stock Exchange
Group Homework
• A mixture of companies from
• Different stock exchanges
• Different industries
• Do NOT choose
• banks (e.g., HSBC)
• insurance companies (e.g., AIA)
• utility companies (e.g., HK Electric)
• Exchange Traded Funds (ETF) (e.g., the Tracker
Fund of Hong Kong)
• Real Estate Investment Trusts (REITs, e.g., The
LINK REITs)
Chapter 19: Agency Problems and
Corporate Governance

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Topics Covered
• What Agency Problems Should You
Watch Out For?
• Monitoring by the Board of Directors.
• Monitoring by Shareholders.
• Monitoring by Auditors, Lenders, and
Potential Acquirers.
• Management Compensation.
• Governance Regimes Around the World.
• Do these Difference Matter?
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The Principal Agent Problem

• Shareholders = Owners (Principal)

• Managers = Employees (Agent)
• Who has the power?
• There may be conflict of interest between
shareholders and managers
• For firms with a controlling shareholder,
the main conflict is between major and
minor shareholders – more on this later

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The Principal Agent Problem

Agency costs reduce firm value due to

agency problems:
• Value lost because managers do not make
value‐maximizing decisions.
• Costs of monitoring managers, setting
rules and procedures to mitigate agency
problems, and intervening when agency
problems are sufficiently severe.

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Agency Problems to Watch Out For 1

1. Not put in sufficient effort.

2. Fritter away cash on perquisites and
private benefits.
3. Overinvest in the search for power or
prestige ‐ Entrenching investment due to
• Compensation
• Personal prestige / social status

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Agency Problems to Watch Out For 2

4. Be reluctant to take risks or take too

many risks.
• Managers hesitate to take on necessary,
successful risky activities
• Managers compensated with stock options
have incentive to take excessive risk
5. Focus on short‐term results at the
expense of long‐term value

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Monitoring by Boards of Directors: US and
other common‐law countries/regions
Board Independence
• NYSE and NASDAQ require a majority independent.
About 90% are independent in practice
• LSE also requires a majority independent
• HKSE requires a minimum of 3 independent directors
Board Size
• Not too big to generate a free‐rider problem.
• Not too small to be unable to tackle the complexities of
the business

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Monitoring by Boards of Directors: US and
other common‐law countries/regions
Overboarding
• Director serving on too many boards (busy
directors)
Frequency of Elections
• Elections are conducted annually for most
companies
• However, some US companies have staggered
boards – typically only one‐third of directors
are annually elected on a rotational basis

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Continental European Boards of
Directors
Germany: Codetermination with two‐tiered
boards
• Supervisory board with one‐third (half) of the
directors being employees for companies with fewer
(more) than 2,000 employees.
• Management board, elected by the supervisory board
France: One‐ or Two‐tiered
• Conseil de surveillance – similar to German’s
supervisory board
• Directoire – Management board
• Most French companies don’t have a supervisory
board
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Monitoring by Shareholders

Shareholders can directly monitor the

company by removing underperforming
board through voting – shareholder
democracy!
• Binding – votes on director appointment or decision to
merge; Advisory – votes on executive compensation or
environmental policies
• Proxy Fight – shareholders can nominate their directors
to run against those nominated by management
• Very expensive!

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Monitoring by Shareholders
• Dual‐Class Equity – Most companies have one class of
shares, but it is common in the new technology
companies to have two classes of shares with different
voting rights
• Facebook (Meta) sold to the public the A shares, which had
one vote per share, while the B shares retained by the
founders have 10 votes per share!
• Engagement – Large, activist shareholders, especially
hedge fund investors, can engage management to force
changes
• Governance through exit – Voting and engagement are
referred to as ‘governance through voice.’ Shareholders
can take “Wall Street Walk” by selling shares.
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Monitoring by Auditors, Lenders, and
Potential Acquirers
Auditors
• Ensure companies’ financial statements are prepared
according to relevant accounting standards
Lenders
• Banks track a company’s assets to ensure timely
repayment of their loans
Takeovers
• Outside investors can acquire enough shares to force
out underperforming incumbent management

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Management Compensation

• While monitoring helps to reduce

agency problems (a ‘stick’ approach), a
‘carrot’ approach may be more effective!
• Rewarding good behaviors are as important as
punishing bad behaviors

• Management compensation must be

designed to provide the right incentives
• Motivate managers to align their interests with
shareholders’ interests

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Figure 19.1 CEO Compensation, 2016
Average annual CEO compensation worldwide in 2017, by country (in
millions U.S. dollars).

Source: https://www.statista.com/statistics/424154/average‐annual‐ceo‐compensation‐worldwide/.

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Figure 19.2 Median CEO Compensation
Median total compensation 1992–2019 for CEOs in S&P Index.

Source: Execucomp.

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Figure 19.3 Form of CEO Compensation
Median total compensation 1992–2019 for CEOs in S&P Index.

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Governance Regimes around the World

• Governance regimes critically depend on

ownership structure
• Ownership structure, in turn, depends
on a country’s legal origin
• Much more concentrated in civil law countries

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Agency problems for firms with
controlling shareholders
• Controlling shareholders (or their
representatives) most likely are also top
executives
• The main concern is the conflict of
interest between controlling
shareholders and minority shareholders
• All the monitoring mechanisms
discussed above don’t apply
• E.g., takeovers unlikely

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Agency problems for firms with
controlling shareholders
• Expropriations by controlling
shareholders can take many forms
• The majority shareholder of a Russian company did
a consolidation of 136,000 existing shares into one
new share – eliminated existing shareholders who
held less than 136,000 shares!

• Other less blatant ‘tunneling’ can be

achieved through related‐party
transactions
• At what prices would a listed company buy (sell) an
asset from(to) the controlling shareholder?
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Figure 19.5 Ownership and Control in Other
Countries

Source: G. Aminadav and E. Papaioannou, “Corporate Control around the World,” Journal of Finance 75 (June 2020),
pp. 1191–1246.

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Ownership and Control in Other Countries

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Ownership and Control in Other Countries

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Ownership and Control in Other Countries

Ownership and Control in Japan

• Keiretsu

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Ownership and Control in Other Countries

Ownership and Control in Germany

• Banks.
• Deutsche Bank.
• Daimler AG example.

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Figure 19.4 (a) Ownership of Daimler‐Benz,1990

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Figure 19.4 (b) Ownership of Daimler, 2014

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Figure 19.6 Share Ownership in 2012 of the
French Luxury Goods Company LVMH

Source: G. Aminadav and E. Papaioannou, “Corporate Control around the World,” Journal of Finance 75 (June 2020),
pp. 1191–1246.

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Do These Differences Matter?
Public Market Myopia—Mixed Results on whether the
market‐based system leads to short‐termism.
Growth Industries and Declining Industries
• Market‐based systems better for new industries.
• Market‐based systems better for forcing out declining
industries.
• Transparency favors market‐based systems.
• Opacity favors bank‐based systems.

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