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Abstract:
This Article begins by identifying five forces of change that have profound implications for corporate governance in contemporary society. These forces involve changes in the nature of work, capital markets, product markets, organizational forms, and the corporate regulatory environment. It then examines the implications of these changes for corporate governance. It reviews the empirical literature in finance and strategy and concludes that much of this literature is cross-sectional in nature, and therefore is incapable of predicting the consequences of these changes.

The Article discusses the prominent paradigms that are found throughout corporate governance scholarship. Stripped of their complexities, most of the literature centers around a debate between two opposing views of the corporation: contractarianism and communitarianism. The Article describes these two views of the public corporation, examines how each addresses the impact of the five forces of change that we have identified, and critiques the limitations of each view. The Article concludes that, in a world of rapid change, the contractarian view provides the better perspective for public policy toward the large-scale, public corporation. While there are important limitations of the contractarian view (for example, third-party effects and problems deriving from ill-defined property rights), on balance, the ability of individuals to engage freely in mutually beneficial contracting is the most efficient way of adapting to these governance challenges. The Article also revisits the debate surrounding the American Law Institute's Corporate Governance Project. While the Project addresses issues that might be interpreted as affirming the communitarian perspective, it clearly asserts the primacy of shareholder wealth-maximization, a fundamental tenet of the contractarian perspective.

The Article examines in detail the governance structures in Japan and Germany--structures that are quite communitarian compared to the relatively contractarian U.S. structure--to determine whether these alternative governance systems provide any better blueprints for adapting to change. The Article concludes that the communitarian perspectives adopted by these countries impede the ability to adapt to change. Further, the Article provides evidence that global corporations in these countries are inexorably patterning their governance practices and styles along Anglo-American, or more precisely, U.S. lines.

The argument that the world is inexorably evolving along the lines of the contractarian model is an important and unique conclusion of this Article. Most who have written on the subject to date have concluded that there is no "optimal" governance structure and that both the Japanese and German systems are efficient, self-sustaining forms as well. The authors disagree. There is sufficient theory and evidence to support the assertion that public corporations around the world are moving toward a more contractarian, and specifically, more U.S.-styled governance structure. Moreover, this movement is, in large part, a response to the fundamental changes that are identified in the Article.

The Article does not conclude in a state of contractarian euphoria, however. Effective cross-border institutions must be developed in order to reduce the two major shortcomings of the contractarian system. First, effective contracts cannot be written when property rights are ill-defined or the terms of contracts cannot be enforced--regulatory "voids" at the intersection of sovereign boundaries, and impediments to a well-functioning international market for corporate control exacerbate this problem. Therefore, the establishment of international standards, institutions, and rules of law that facilitate free contracting across borders is needed. Second, the potential costs and abuses of externalities (third-party effects) are pernicious. Whenever possible, mechanisms must be developed to internalize the costs of such externalities.

Abstract:
We provide evidence on the covenant structure of corporate loan agreements. Building on the work of Jensen and Meckling (1976), Myers (1977) and Smith and Warner (1979), we summarize and test the implications for what we refer to as the Agency Theory of Covenants (ATC), using a large sample of privately placed corporate debt. Our results are consistent with many of the implications of the ATC, including a negative relation between the promised yield on corporate debt and the presence of covenants. We also find that borrower and lender characteristics, as well as macroeconomic factors, determine covenant structure. Loans are more likely to include protective covenants when the borrower is small, has high growth opportunities or is highly levered. Loans made to investment banks and syndicated loans are also more likely to include protective covenants, as are loans made during recessionary periods or when credit spreads are large. Finally, we show that consistent with the ATC, firms that elect to issue private rather than public debt are smaller, have greater growth opportunities, less long term debt, fewer tangible assets, more volatile cash flows and include more covenants in their debt agreements. An important byproduct of our analysis is to demonstrate empirically that covenant structure and the yield on corporate debt are determined simultaneously.

Abstract:
We provide evidence on the covenant structure of corporate loan agreements. Building on the work of Jensen and Meckling (1976), Myers (1977) and Smith and Warner (1979), we summarize and test the implications for what we refer to as the Agency Theory of Covenants (ATC), using a large sample of privately placed corporate debt. Our results are consistent with many of the implications of the ATC, including a negative relation between the promised yield on corporate debt and the presence of covenants. We also find that borrower and lender characteristics, as well as macroeconomic factors, determine covenant structure. Loans are more likely to include protective covenants when the borrower is small, has high growth opportunities or is highly levered. Loans made by investment banks and syndicated loans are also more likely to include protective covenants, as are loans made during recessionary periods or when credit spreads are large. Finally, we show that consistent with the ATC, firms that elect to issue private rather than public debt are smaller, have greater growth opportunities, less long term debt, fewer tangible assets, more volatile cash flows and include more covenants in their debt agreements. An important byproduct of our analysis is to demonstrate empirically that covenant structure and the yield on corporate debt are determined simultaneously.

Keywords: Bond Covenants, Costly Contracting hypothesis, Bank Loans, Corporate Debt, Agency Costs, Simultaneity

Abstract:
We examine the characteristics, strategies, and performance of acquirers in 12,476 completed US acquisitions. We document that a portfolio of acquiring firms significantly outperformed market benchmarks during the 1990s, and that frequent acquirers outperformed infrequent acquirers. This outperformance reflects superior stock price performance that occurs before, not after, acquisition announcements, implying that it is good performance that begets acquisitions rather than the reverse. In addition to this pre-acquisition stock price run-up, in the vast majority of cases, we observe a statistically and economically significant positive market reaction to the acquisition announcement itself. Further, we find that acquirer size is not the most important determinant of the market reaction to an acquisition announcement. Instead, the target organizational form – i.e., whether the target is public or non-public – dominates all else. In addition, the size of the target and the medium of exchange are at least as important as acquirer size. Our empirical results lead us to conclude that the widely accepted attributions of “hubris” and “agency costs” to the motivations of the managers of acquiring firms are perhaps overstated, since they apply only to a small subset of cases where the target is relatively large and publicly traded, and stock is used as the sole medium of exchange. A substantial portion of M&A activity is consistent with shareholder value-maximizing behavior.

Mergers, acquisitions, public targets, non-public targets, acquirer strategy

Abstract:
We examine the effects of inflation on the standard, Constant-Growth valuation model found throughout the finance literature. We find that the presence of inflation vitiates the generally accepted expression of this model for the value of a firm that either makes no new investments or invests only in zero net present value projects. If expected inflation is positive, the generally accepted and widely used expression for the value of the firm under either of these two conditions seriously understates the true value of the firm, even at modest levels of inflation. For example, assuming zero net new investments, a real interest rate of 6% and a rate of inflation of 2%, the commonly accepted expression understates the true value of the firm by 25%. We also examine the effects of inflation on the firm's weighted-average cost of capital (WACC), which is an important parameter in the Constant-Growth model. We find that the popular WACC equation developed by Modigliani and Miller is not inflation-neutral when stated in nominal terms. Specifically, when expected inflation and corporate tax rates are positive, the nominal M&M WACC understates the firm's true nominal WACC by a non-trivial amount. We show how to adjust the standard M&M formula to correct for this understatement. In contrast to the M&M model, we find that the WACC equation developed by Miles & Ezzel is inflation-neutral when stated in nominal terms, and thus, there is no need to adjust the equation in the presence of positive expected inflation. We conclude the paper by documenting the widespread misapplication of the Constant-Growth model under conditions of inflation found throughout the finance literature and in the practical application of corporate valuation techniques.

Valuation, Inflation, WACC

Abstract:
This study examines the empirical relations between the governance structure of public corporations in the United States and the rating and pricing of their debt securities. We study an unbalanced panel of 775 unique U.S. firms from 2001 through 2007 and identify several statistically significant relations between corporate governance factors and credit ratings, bond spreads and firm values. We find that credit ratings are negatively related to the presence of antitakeover measures for firms with speculative grade ratings and positively related to the presence of antitakeover measures for firms with investment grade ratings. Moreover, we find that spreads are positively related to the presence of antitakeover measures, and this relation is significantly stronger for firms with less than investment grade credit ratings. Our findings also suggest that more stable boards, defined as having attributes relating to board tenure, director liability indemnification and classified board structures are related to higher credit ratings and lower bond spreads. We conjecture that boards with greater stability may be better positioned to take into consideration the longer term interests of the firm as a whole, thus benefiting the firm's creditors.

corporate governance, credit risk, bond yields, bond spreads

Abstract:
We analyze the effects of changes in the purpose of large German corporations from stakeholder-oriented organizations to shareholder-oriented organizations during the decade of the 1990s. We document this transformation by first examining the annual reports of large firms at strategic points in time relative to significant changes in German corporate law. We find that changes in the law over this period both reflected and facilitated a fundamental shift in the operations of German corporations as evidenced by their adoption of stock- and option-based incentive compensation plans, adoption of US GAAP-based (or related) accounting systems, ADR listings, and restructuring activity. We also document the emergence and adoption of the rhetoric of shareholder value among German managers, the public, and the media. Detailed empirical analysis shows that German firms that embraced shareholder value as their corporate purpose and operating strategy realized a slight gain in equity values over the decade of the 1990s, as well as a significant increase in their Betas relative to the S&P 500, when compared to less shareholder-oriented firms. We interpret the Beta shifts as evidence that focusing on shareholder value leads firms to adopt entrepreneurial risk-taking strategies that reflect shareholder, rather than stakeholder, concerns. We conjecture that the increase in Betas might also be due to the adoption by some German firms of a similar operating philosophy to that of the traditionally shareholder-oriented US corporation. Finally, we show that German firms that embraced shareholder value-orientation during the 1990s realized significantly greater growth in their Market-to-Book ratios and market capitalizations relative to their less shareholder-oriented counterparts.

Corporate Governance, Shareholder Value, Germany, Corporate Goals

Abstract:
Using a unique hand-collected dataset, we show that shareholder activism designed to open U.S. based closed-end funds has become more frequent since the SEC's reform of the proxy rules in 1992 (the 1992 Reform) that lifted restrictions on shareholder communication. We denote this activity activist arbitrage and distinguish it from the standard pure trading arbitrage. We document a dual relationship between activist arbitrage and funds' discounts: a high discount increases the probability of activist arbitrage, while a high probability of ex post activist arbitrage reduces the ex ante discount. We provide evidence that the ease of shareholder communication is a major determinant for the emergence of activist arbitrage. This holds for the time series - activist arbitrage has become much more common following the 1992 Reform - as well as for the cross section - activist arbitrage is more likely in funds that exhibit low costs of communication. Overall, our results provide direct evidence of the presence of arbitrage activities, but also demonstrate how costly communication leads to limits on arbitrage.

Limits to Arbitrage, Communication, Shareholder Activism, Closed-End Funds

Abstract:
This study examines the empirical relations between the governance structure of public corporations in the United States and the credit ratings and pricing of their debt securities. We study an unbalanced panel of 775 unique firms from 2001 through 2007. Consistent with the existing literature, we find that the primary determinant of a firm's credit rating is its financial condition. However, governance attributes relating to transparency, ownership structure, shareholder rights, board structure and executive compensation are significantly related to credit ratings as well, even after accounting for the financial condition of the firm. We also find that the presence of anti-takeover measures is associated with higher credit scores for firms with investment grade debt and lower for firms with speculative grade debt. Finally, our empirical results suggest that stable boards, defined as boards having attributes relating to tenure, liability indemnification and classified board structures, have higher credit ratings and lower bond spreads. We conjecture that boards with greater stability may be better positioned to take into consideration the longer term interests of the firm as a whole, thereby benefiting the firm's bondholders.

corporate governance, credit risk, credit rating, bond spreads

Abstract:
In October 2000 a hedge fund holding an unpaid debt claim won an enormous victory against the debtor, the Republic of Peru, through an opportunistic interpretation of the common pari passu clause by a Brussels court. This development was met by charges from policy makers and practitioners that the court's decision (its novel interpretation of the pari passu clause) would lead to a dramatic increase in the risks of holdout litigation faced by sovereign debtors. Over the ensuing years, multiple reform solutions were proposed including the revision of certain contractual terms, the filing of amicus briefs in a key case, and the imposition of an international bankruptcy regime for sovereigns. The question, looking back, that this Article empirically investigates is whether the capital markets actually perceived a significant increase in risk at the time of the October 2000 Brussels court decision. Equally important is whether markets discriminate among competing versions of the pari passu clause based on their relative risks for holdouts. And, to the extent the markets did react to the increase in legal risk, did any of the antidotes that were implemented to reduce the supposed increased holdout risk work? We offer evidence that bond prices did respond to this legal shock, that markets do discriminate based on the relative holdout risk posed by differing forms of the pari passu clause, and provide surprising evidence regarding the efficacy of the government-sponsored antidote, the advent of collective action clauses.

Abstract:
The authors also show that the Weighted Average Cost of Capital (WACC), as developed by Modigliani and Miller (M&M), will be misleading if inflation is positive. They provide an adjustment factor that corrects this deficiency of the M&M model. Finally, the authors show that the WACC formula developed by Miles and Ezzell is correct when the parameters are stated in nominal terms, and therefore no adjustment is necessary. In the presence of inflation, the standard Constant-Growth valuation model found throughout the finance literature is not valid in cases where a company either (1) makes no net new investments or (2) invests only in zero Net Present Value projects. If expected inflation is positive, the generally accepted and widely used expression for the value of the firm under either of these two conditions seriously understates the true value of the firm, even with modest levels of inflation. The authors also show that the Weighted Average Cost of Capital (WACC), as developed by Modigliani and Miller (M&M), will be misleading if inflation is positive. They provide an adjustment factor that corrects this deficiency of the M&M model. Finally, the authors show that the WACC formula developed by Miles and Ezzell is correct when the parameters are stated in nominal terms, and therefore no adjustment is necessary.

Abstract:
We explore the role of expected cash flow volatility as a determinant of dividend policy both theoretically and empirically. Our simple one period model demonstrates that, given the existence of a stock-price penalty associated with dividend cuts, managers rationally pay out lower levels of dividends when future cash flows are less certain. The empirical results use a sample of REITS from 1985-1992 and confirm that payout ratios are lower for firms with higher expected cash flow volatility as measured by leverage, size and property level diversification. These results are consistent with information-based explanations of dividend policy but not with agency cost theories.

Abstract:
We look for asymmetries in the dynamics of real GDP growth for the G7 countries, using a model by Beaudry and Koop that allows the depth of a recession to influence the rate of growth of output. We find evidence supporting these nonlinearities in four countries, including the United States, but we do not find evidence that the asymmetries are common even among the four countries exhibiting asymmetric behavior. A modification of the model to distinguish between the recession and recovery phases of a business cycle does not change this general finding. The asymmetries discovered by Beaudry and Koop do not appear to be common among the G7 nations.

Abstract:
This paper examines the effect of the 1978 Bankruptcy Reform Act on the wealth of corporate stockholders. Employing a sample of 535 bankruptcy filings of exchange listed firms between 1963 and 1992, the paper documents that stockholders of firms filing after the Act suffer significantly greater losses than stockholders filing in the earlier period. Evidence is presented that indicates that these greater losses are not due to greater operating losses or a general deterioration in economic conditions. While relatively more firms are reorganized in the post-Act period, a greater fraction of these firms emerge from bankruptcy with a zero equity position. These results call into question the widespread belief that the greater control given corporate managers over the bankruptcy process by the 1978 Act has redounded to the benefit of corporate stockholders.

Abstract:
In this study, we explore the role of expected cash flow volatility as a determinant of dividend policy. We first demonstrate that returns are increasing in dividend payout. But, we show that responses to changes in dividends are less sensitive to the magnitude of the change than to the sign of the change. We next develop a simple two period model which demonstrates that, given the existence of a large stock price penalty associated with dividend cuts. Managers rationally pay out lower levels of dividends when future cash flows are less certain. Our final empirical results show that payout ratios are lower for those firms that are smaller, more levered and less diversified. This result is consistent with information based explanations but not with agency cost theories.

Abstract:
We show that entrepreneurs may prefer to allow insider trading even when it is not socially optimal. We examine a model in which an insider/manager allocates resources on the basis of his private information and outside information conveyed through the secondary-market price of the firm's shares. If the manager is allowed to trade, he will compete with informed outsiders, reducing the equilibrium quality of outside information. While the benefits to production of outside information are the same for society and entrepreneurs, we show that the social and private costs are different. Thus, entrepreneurs and society may disagree on the conditions under which insider trading restrictions should be imposed.