Tag: Control rights

Creeping Acquisitions in Europe

The following post comes to us from Luca Enriques, Allen & Overy Professor of Corporate Law at University of Oxford, Faculty of Law, and Matteo Gatti of Rutgers School of Law–Newark.

Creeping acquisitions—surreptitious grabs of a public company’s control without the prior launch of a formal tender offer—had long been considered a thing from the past in corporate America: poison pills kept this acquisition technique at bay. After Sotheby’s, Allergan and similar “wolf pack”-styled hedge fund activists’ campaigns, some fear creeping acquisitions might be back.

Other than in the U.S., becoming targets of a creeping acquisition has never ceased to be a real possibility for European companies with a dispersed ownership structure: without pills or analogue structural defenses available (or, at least, in place), they run the risk of being taken over through such an acquisition technique. Indeed, acquirers have made significant attempts to that effect over the last decade or so—sometimes successfully (Schaeffler’s takeover of Continental, Lactalis’ acquisitions of Parmalat), sometimes not (LVMH’s failed attack on Gucci, Nasdaq’s attempt at the London Stock Exchange Group). In our paper Creeping Acquisitions in Europe: Enabling Companies to Be Better Safe than Sorry, we analyze the level and type of protections European companies can find in the law (whether EU or national) and via private ordering (which of course is constrained by the law itself).


Piercing the Corporate Veil

Editor’s Note: The following post comes to us from Michael Hutchinson, partner at Mayer Brown LLP, and is based on a legal update by Mr. Hutchinson and Martin Mankabady.

The Supreme Court’s decision in the case of Petrodel v Prest, handed down June 12, 2013, marks a crucial shift in the extent to which the courts will allow the “piercing of the corporate veil”. Although the case revolved around a matrimonial dispute, it has profound implications for corporate governance.

The Facts

In October 2011, the High Court ruled that Mrs Prest (“W”) was entitled to a divorce settlement of £17.5 million from Mr Prest (“H”), a wealthy oil trader. Since H failed to comply with court orders by failing to give full and frank disclosure of his finances during proceedings, his appeal was dismissed at a preliminary stage. The award therefore stood regardless of later court decisions concerning enforcement.

In terms of enforcement of the award, Moylan J ordered that properties in London and overseas, owned by Petrodel Resources and two other companies (collectively “X”) were assets of H and formed part of the divorce settlement since they were beneficially owned by H as the sole shareholder. Whilst Moylan J found there had been no impropriety in relation to X, so as to permit the corporate veil to be pierced, he nevertheless held that H, exercising complete control over X both in terms of their operation and management, was ‘entitled’ to the relevant properties within the meaning of s24(1)(a) Matrimonial Causes Act 1973 (“MCA”), despite not personally owning the assets.

X appealed to the Court of Appeal, submitting that in order for company assets to become subject to s24(1)(a) MCA, the corporate veil would have to be pierced and this only occurred in exceptional circumstances, this not being one of them.


The Separation of Investments and Management

The following post come to us from John Morley, Associate Professor of Law at University of Virginia School of Law.

This paper suggests that the essence of these funds and their regulation lies not just in the nature of their investments, as is widely supposed, but also—and more importantly—in the nature of their organization.

Specifically, every enterprise that we commonly think of as an investment fund adopts a pattern of organization that I am calling the “separation of investments and management.” These enterprises place their securities, currency and other investment assets and liabilities into one entity (a “fund”) with one set of owners, and their managers, workers, office space and other operational assets and liabilities into a different entity (a “management company” or “adviser”) with a different set of owners. Investment enterprises also radically limit fund investors’ control. A typical hedge fund, for example, cannot fire and replace its management company or its employees—not even by unanimous vote of the fund’s board and equity holders.

I explain this pattern of organization and explore its costs and benefits. I argue, paradoxically, that the separation of investments and management benefits fund investors by limiting their control over managers and their exposure to managers’ profits and liabilities.


How Costly Is Corporate Bankruptcy for Top Executives?

The following post comes to us from B. Espen Eckbo, Professor of Finance at the Tuck School of Business at Dartmouth College; Karin Thorburn, Professor of Finance at the Norwegian School of Economics; and Wei Wang, Assistant Professor of Finance at Queen’s School of Business.

To what extent are CEOs filing for bankruptcy tainted by the bankruptcy event? On the one hand, the CEO bears a major responsibility for the firm going broke. After all, the filing might have been avoided if the CEO had managed to reduce firm leverage or otherwise reorganize debt claims in time to stay out of court. On the other hand, CEOs going through bankruptcy likely gain valuable experience from the crisis. The net impact of these two opposing effects on executive reputation is an open empirical question.

In the paper, How Costly is Corporate Bankruptcy for Top Executives?, which was recently made publicly available on SSRN, we provide some first systematic estimates of top executives’ personal costs of corporate bankruptcy. The estimates are based on 324 large public companies filing for Chapter 11 bankruptcy over the past two decades.

The study provides evidence on the following three questions. First, do top executives experience large personal losses (both income and wealth) when filing for bankruptcy? Second, do creditor control rights influence the probability of CEO departure and the income losses? Third, do ex ante predicted personal losses affect CEO’s decision to leave the firm and their compensation contract design?


Taxing Control

The following post comes to us from Richard M. Hynes, Professor of Law at University of Virginia School of Law.

Early corporate law scholarship argued both that anti-takeover devices are inefficient (they reduce the value of the firm) and that firms adopt efficient governance terms before they make their initial public offering. Some of this scholarship asserted that firms go public without anti-takeover devices and adopt them later when agency costs are higher. However, subsequent research revealed that most firms adopt anti-takeover devices before completing their initial public offerings. For example, over eighty-six percent of firms that have gone public in 2012 have a staggered board of directors, and both Google and Facebook chose dual-class capital structures that allow the founders to retain voting control disproportionate to their economic stake.

The literature offers a number of explanations for this apparent puzzle. Capital market imperfections may prevent initial public offering prices from reflecting differences in corporate governance terms. Firms may choose inefficient terms due to bad legal advice or because of frictions in the market for financing prior to the initial public offering. Anti-takeover protections could be efficient after all, at least for some firms, because they correct for myopic investors or some other problem. Finally, managers may choose anti-takeover provisions to signal something about their firms. In an essay forthcoming in the Journal of Corporation Law I offer a very different explanation, one based on the tax code.

My argument begins with a variant of one of the existing explanations for anti-takeover protections. The heart of the argument is that managers are not driven solely by a desire for material gain but derive some happiness or utility from the control they exercise over their firm. To the extent that managers derive happiness from control, they may not choose governance terms that maximize the dollar value of the firm. However, unless there is some contracting failure, they will still choose efficient terms — terms that maximize the total value of the firm (the dollar value plus the control value).


A Theory of Empty Voting and Hidden Ownership

The following post comes to us from Jordan M. Barry, Associate Professor of Law at the University of San Diego School of Law, John William Hatfield, Assistant Professor of Political Economy at the Stanford Graduate School of Business; and Scott Duke Kominers, Research Scholar at the Becker Friedman Institute for Research in Economics at the University of Chicago.

In our recent paper, On Derivatives Markets and Social Welfare: A Theory of Empty Voting and Hidden Ownership, we build and explore a formal theoretical framework to understand interactions between derivatives markets and shareholder voting behavior.

Ownership of stock in a corporation entails two types of rights with respect to that corporation. First, shareholders have economic ownership rights that entitle them to share in corporate profits. Second, they have certain legal rights of control over the corporation. These economic and control rights come bound together with each share of stock, but they can be separated, or decoupled. Decoupling can result in empty voting, in which an actor’s voting interest in a corporation is larger than her economic interest. It can also lead to hidden ownership, in which an actor’s economic interest in a corporation exceeds her voting interest. Decoupling raises a host of concerns because it turns the conventional logic for granting shareholders voting rights—their economic interest in the corporation—on its head. (See references here.)


Derivatives Trading and Negative Voting

Holger Spamann is an assistant professor at Harvard Law School.

Securities regulators, practitioners, and legal commentators worry that derivatives may provide shareholders and creditors incentives to destroy value in their corporation (references here). The basic concern is that if shareholders or creditors own a sufficient amount of off-setting derivatives such as put options or credit default swaps (CDS), any losses on their shares or debt will be more than off-set by the corresponding gains on their derivatives (“over-hedging”). In this case, shareholders and creditors benefit by using the control rights inherent in their shares or debt to reduce the corporation’s value (“negative voting”).

An important question that is generally not considered, however, is whether it would ever be profitable for shareholders or creditors to acquire so many derivatives in the first place. After all, any gains to shareholders and creditors come at the expense of their counterparties on their derivative contracts. These counterparties would therefore prefer not to sell the derivatives, or only at a price that compensates them for the future payouts, thus depriving shareholders and creditors of any profit in the overall scheme. This is an important difference from the related problem of vote-buying, which forces (dispersed) counterparties into a collective action problem approaching a prisoners’ dilemma. By contrast, derivative counterparties have the option simply to abstain from the transaction.


Creditor Control Rights, Corporate Governance, and Firm Value

The following post comes to us from Greg Nini of the Insurance and Risk Management Department at the University of Pennsylvania, David Smith of the School of Commerce at the University of Virginia, and Amir Sufi of the Finance Department at the University of Chicago.

In the paper, Creditor Control Rights, Corporate Governance, and Firm Value, which was recently made publicly available on SSRN, we provide evidence that creditors play an active role in the governance of corporations well outside of payment default states. By examining the SEC filings of all U.S. nonfinancial firms from 1996 through 2008, we document that, in any given year, between 10 percent and 20 percent of firms report being in violation of a financial covenant in a credit agreement.


Ownership Structure and the Cost of Corporate Borrowing

The following post comes to us from Chen Lin, Professor of Finance at the Chinese University of Hong Kong; Yue Ma, Professor of Economics at Lingnan University, Hong Kong; Paul Malatesta, Professor of Finance at the University of Washington; and Yuhai Xuan, Assistant Professor of Business Administration at the Finance Unit of Harvard Business School.

In the paper, Ownership Structure and the Cost of Corporate Borrowing, forthcoming in the Journal of Financial Economics, we study the financial consequences of the divergence between control rights and cash-flow rights in a large sample of companies across 22 East Asian and Western European countries during the period from 1996 to 2008. Specifically, we analyze the effects of control rights-cash-flow rights divergence on firms’ cost of borrowing and provide new insights into the link between the separation of ownership and control and corporate value.


Satisficing Contracts

This post comes from Patrick Bolton of Columbia Business School.

In my working paper Satisficing Contracts which I recently presented at the Law, Economics and Organizations Workshop here at Harvard Law School, my co-author Antoine Faure-Grimaud and I analyze a contracting model with two agents, each facing thinking costs, in which equilibrium incomplete contracts arise endogenously. The basic situation we model is an investment in a partnership or an ongoing new venture. The contract the agents write specifies in a more or less complete manner what action-plan they agree to undertake initially, and how the proceeds from the venture are to be shared. In any given state of nature both agents face costs in thinking through optimal decisions in that state. Therefore an optimal contract that maximizes gains from trade net of thinking costs is generally incomplete in the sense that it is not based on all the information potentially available to agents in all states of nature. By introducing positive thinking or deliberation costs into an otherwise standard contracting framework, it is thus possible to formulate a theory of endogenously incomplete contracts.

The main results from our analysis are as follows: First, incomplete contracts specifying control rights may emerge in equilibrium (when such contracts are not strictly dominated by a complete contract with the same equilibrium information acquisition). The rationale for control rights in our model—defined as rights to decide between different transactions in contingencies left out of the initial contract—is that the holder of these rights benefits by having the option to defer thinking about future decisions. Second, control rights tend to be allocated to the more cautious party. Indeed, the more cautious party is then more willing to close the deal quickly, even though it has not had the time to think through all contingencies, in the knowledge that thanks to its control rights it can impose its most favored decision in the unexplored contingencies. Third, the sharp distinction between a first contract negotiation phase followed by a phase of execution of the contract usually made in the contract theory literature is no longer justified in our setup. In particular, the contracting agents may choose to begin negotiations by writing a preliminary contract specifying the broad outlines of a deal and committing the agents to the deal. Fourth, when agents’ objectives conflict more, equilibrium contracts are more complete. The main reason is that each agent may be concerned about the detrimental exercise of control by the other agent, so that abuse of power cannot be limited by just allocating control to the agent that is least likely to abuse power. In such situations the exercise of control may have to be circumscribed contractually by writing more complete contracts. Another reason is that when agents have conflicting goals they are less willing to truthfully share their thoughts, so that the net benefit of leaving transactions to be fine-tuned later is reduced.

Our analysis thus provides new foundations for incomplete contracts and the role of control rights. In particular, our framework allows for contractual innovation by the contracting agents independently of any changes in legal enforcement. In addition, changes in legal enforcement may have no effect on equilibrium contracts if enforcement constraints were not binding in the first place. The full paper is available for download here.