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Abstract: This paper integrates elements from the theory of agency, the theory of property rights and the theory of finance to develop a theory of the ownership structure of the firm. We define the concept of agency costs, show its relationship to the 'separation and control' issue, investigate the nature of the agency costs generated by the existence of debt and outside equity, demonstrate who bears the costs and why, and investigate the Pareto optimality of their existence. We also provide a new definition of the firm, and show how our analysis of the factors influencing the creation and issuance of debt and equity claims is a special case of the supply side of the completeness of markets problem.
Agency costs and theory, internal control systems, conflicts of interest, capital structure, internal equity, outside equity, demand for security analysis, completeness of markets, supply of claims, limited liability
Abstract: This paper examines the role of the corporate objective function in corporate productivity and efficiency, social welfare, and the accountability of managers and directors. I argue that since it is logically impossible to maximize in more than one dimension, purposeful behavior requires a single valued objective function. Two hundred years of work in economics and finance implies that in the absence of externalities and monopoly (and when all goods are priced), social welfare is maximized when each firm in an economy maximizes its total market value. Total value is not just the value of the equity but also includes the market values of all other financial claims including debt, preferred stock, and warrants. In sharp contrast stakeholder theory, argues that managers should make decisions so as to take account of the interests of all stakeholders in a firm (including not only financial claimants, but also employees, customers, communities, governmental officials, and under some interpretations the environment, terrorists, and blackmailers). Because the advocates of stakeholder theory refuse to specify how to make the necessary tradeoffs among these competing interests they leave managers with a theory that makes it impossible for them to make purposeful decisions. With no way to keep score, stakeholder theory makes managers unaccountable for their actions. It seems clear that such a theory can be attractive to the self interest of managers and directors. Creating value takes more than acceptance of value maximization as the organizational objective. As a statement of corporate purpose or vision, value maximization is not likely to tap into the energy and enthusiasm of employees and managers to create value. Seen in this light, change in long-term market value becomes the scorecard that managers, directors, and others use to assess success or failure of the organization. The choice of value maximization as the corporate scorecard must be complemented by a corporate vision, strategy and tactics that unite participants in the organization in its struggle for dominance in its competitive arena. A firm cannot maximize value if it ignores the interest of its stakeholders. I offer a proposal to clarify what I believe is the proper relation between value maximization and stakeholder theory. I call it enlightened value maximization, and it is identical to what I call enlightened stakeholder theory. Enlightened value maximization utilizes much of the structure of stakeholder theory but accepts maximization of the long run value of the firm as the criterion for making the requisite tradeoffs among its stakeholders. Managers, directors, strategists, and management scientists can benefit from enlightened stakeholder theory. Enlightened stakeholder theory specifies long-term value maximization or value seeking as the firm?s objective and therefore solves the problems that arise from the multiple objectives that accompany traditional stakeholder theory. I also discuss the Balanced Scorecard, the managerial equivalent of stakeholder theory. The same conclusions hold. Balanced Scorecard theory is flawed because it presents managers with a scorecard which gives no score--that is, no single-valued measure of how they have performed. Thus managers evaluated with such a system (which can easily have two dozen measures and provides no information on the tradeoffs between them) have no way to make principled or purposeful decisions. The solution is to define a true (single dimensional) score for measuring performance for the organization or division (and it must be consistent with the organization's strategy). Given this we then encourage managers to use measures of the drivers of performance to understand better how to maximize their score. And as long as their score is defined properly, (and for lower levels in the organization it will generally not be value) this will enhance their contribution to the firm.
Value Maximization, Stakeholder Theory, Balanced Scorecard, Multiple Objectives, Social Welfare, Social Responsibility, Corporate Objective Function, Corporate Purpose, Tradeoffs, Corporate Governance, Strategy, Special Interest Groups, Social Responsibility.
Abstract: Explores the survival of organizations in which those individuals who are responsible for decision-making are not the same people who experience the financial impact of the decisions. These types of firms have a separation of ownership and control. Firms are viewed as a nexus of contracts, both written and unwritten. The type of contracts considered are those that allocate the steps in the firm's decision process, define residual claims, and provide avenues for controlling agency problems in the decision process. Two hypotheses are proposed in this analysis. The first holds that separation of residual risk bearing from decision management leads to decision systems that separate decision management from decision control. Examination of this hypothesis is done by considering open corporations, large professional partnerships, financial mutuals, and nonprofits. The three areas probed for this hypothesis are (1) specific knowledge and diffusion of decision functions, (2) diffuse residual claims and delegation of decision control, and (3) decision control in nonprofits and financial mutuals. The second hypothesis holds that by combining decision management and decision control in a few agents, residual claims are restricted to these agents. Support for this hypothesis comes from proprietorships, small partnerships, and closed corporations. (SRD)
Residual claims, Decision control, Delegation of authority, Firm ownership, Management decisions, Risk assessment, Contracts & agreements, Risk management, Decision theory, Agency theory, Firm governance, Organizational structures, Firm control
Abstract: This paper analyzes the survival of organizations in which decision agents do not bear a major share of the wealth effects of their decisions. This is what the literature on large corporations calls separation of ownership and control. Such separation of decision and risk bearing functions is also common to organizations like large professional partnerships, financial mutuals and nonprofits. We contend that separation of decision and risk bearing functions survives in these organizations in part because of the benefits of specialization of management and risk bearing but also because of an effective common approach to controlling the implied agency problems. In particular, the contract structures of all these organizations separate the ratification and monitoring of decisions from the initiation and implementation of the decisions.
Abstract: Understanding human behavior is fundamental to understanding how organizations function, whether they are profit-making firms, non-profit enterprises, or government agencies. Much disagreement among managers, scientists, policy makers, and citizens arises from substantial differences in the way we think about human nature--about their strengths, frailties, intelligence, ignorance, honesty, selfishness, and generosity. In this paper we discuss five alternative models of human behavior that are commonly used (though usually implicitly). They are the Resourceful, Evaluative, Maximizing Model (REMM), Economic (or Money Maximizing) Model, Psychological (or Hierarchy of Needs) Model, Sociological (or Social Victim) Model, and the Political (or Perfect Agent) Model. We argue that REMM best describes the systematically rational part of human behavior. It serves as the foundation for the agency model of financial, organizational, and governance structure of firms.
The growing body of social science research on human behavior has a common message: Whether they are politicians, managers, academics, professionals, philanthropists, or factory workers, individuals are resourceful, evaluative maximizers. They respond creatively to the opportunities the environment presents, and they work to loosen constraints that prevent them from doing what they wish. They care about not only money, but about almost everything--respect, honor, power, love, and the welfare of others. The challenge for our society, and for all organizations in it, is to establish rules of the game that tap and direct human energy in ways that increase rather than reduce the effective use of our scarce resources.
See also the related paper by Jensen Self Interest, Altruism, Incentives, and Agency Theory.
Human behavior, Rationality, Altruism, Self Interest, Perfect Agents, Sociology, Agency Costs
Abstract: The interests and incentives of managers and shareholders conflict over such issues as the optimal size of the firm and the payment of cash to shareholders. These conflicts are especially severe in firms with large free cash flows--more cash than profitable investment opportunities. The theory developed here explains 1) the benefits of debt in reducing agency costs of free cash flows, 2) how debt can substitute for dividends, 3) why diversification programs are more likely to generate losses than takeovers or expansion in the same line of business or liquidation-motivated takeovers, 4) why the factors generating takeover activity in such diverse activities as broadcasting and tobacco are similar to those in oil, and 5) why bidders and some targets tend to perform abnormally well prior to takeover.
Dividend policy, Corporate Payout Policy, Optimal Capital Structure, Optimal Debt, Reivestment Policy, Overinvestment
Abstract: Many people are suspicious of self-interest and incentives and oppose motivating humans through incentives. I analyze the meaning of incentives in the logic of choice and argue that it is inconceivable that purposeful actions are anything other than responses to incentives. Money is not always the best way to motivate people. But where money incentives are required, they are required precisely because people are motivated by things other than money. Self-interest is consistent with altruistic motives. Agency problems, however, cannot be solved by instilling greater altruism in people because altruism, the concern for the well-being of others, does not make a person into a perfect agent who does the bidding of others. I discuss the universal tendency of people to behave in non-rational ways. Though they are Resourceful, Evaluative Maximizers (REMMs) humans are imperfect because their brains are biologically structured so as to blind them from perceiving and correcting errors that cause psychic pain. The result is systematic, non-functional behavior. I discuss a Pain Avoidance Model (PAM) that complements REMM by capturing the non-rational component of human behavior (the crux of human self-control problems). Recognizing these self- control problems leads to an expansion of agency theory since they are a second source of agency costs in addition to those generated by conflicts of interest between people. See also the related paper by Jensen and Meckling The Nature of Man.
Abstract: Currently, we are in the midst of a reexamination of chief executive officer (CEO) remuneration that has more than the usual amount of energy and substance. While much of the fury over CEO pay has been aimed at executives associated with accounting scandals and collapses in the prices of their company's shares, the controversies over GE CEO Jack Welch and NYSE CEO Richard Grasso signal a watershed. In their cases the competence and performance of both men were unquestioned: the issue seems to be the perception that they received "too much" and that there was inadequate disclosure. We provide, history, analysis and over three dozen recommendations for reforming the system surrounding executive compensation. Section I introduces a conceptual framework for analyzing remuneration and incentives in organizations. We then analyze the agency problems between managers and shareholders and between board members and shareholders, and discuss how well designed pay packages can mitigate the former while well designed corporate governance policies and processes can mitigate the latter. We say "mitigate" because no solutions will eliminate these agency problems completely. Since bad governance can easily lead to value destroying pay practices our discussion includes analyses of corporate governance as well as pay design. Because optimal remuneration policies cannot be designed and managed without consideration of the powerful relations and interactions between the financial markets and the firm, its top-level executives and the board, we devote significant space to these factors. Section II offers a brief history of executive remuneration from 1970 to the present. Section III examines and explains the forces behind the US-led escalation in share options. We argue that boards and managers falsely perceive stock options to be inexpensive because of accounting and cash-flow considerations and, as a result, too many options have been awarded to too many people. Section IV defines and discusses the agency costs of overvalued equity as the source of recent corporate scandals. Agency problems associated with overvalued equity are aggravated when managers have large holdings of stock or options. Because neither the market for corporate control or the usual incentive compensation systems can solve the agency problems of overvalued equity, they must be resolved by corporate governance systems. And few governance systems were strong enough to solve the problems. As the overvalued equity problem illustrates, while remuneration can be a solution to agency problems, it can also be a source of agency problems. Section V discusses several widespread problems with pay processes and practices, and suggests changes in both corporate governance and pay design to mitigate such problems: including problems with the appointment and pay-setting process, problems with equity-based pay plans, and problems with the design of traditional bonus plans. We show how traditional plans encourage managers to ignore the cost of capital, manage earnings in ways that destroy value, and take actions to deceive investors and capital markets. Section VI defines and analyzes a new concept: what we call the Strategic Value Accountability issue. This is the accountability for making the link between strategy formulation and choice and the value consequences of those choices - basically the link between internal managers and external capital markets. The critical importance of this accountability, its assignment, and its implications for performance measurement and remuneration have long been unrecognized and therefore ignored in most organizations. Section VII analyzes the complex relationships between managers, analysts, and the capital market, the incentives firms have to manage earnings to meet or beat analyst forecasts, and shows how managers playing the earnings-management game systematically erode the integrity of their organization and destroy organizational value. We highlight the puzzling equilibrium in this market that seems to suggest collusion between analysts and managers at the expense of investors - an area that is ripe for further research.
Executive Remuneration, Remuneration Policies, Audit Committee, Incentives, Compensation, Incentives, Strategic Value Accountability, Share options, Overvalued Equity, Earnings Game, Corporate Fraud, Corporate Scandals, Overpayment, Agency Costs, Agency problems, Corporate Governance
Abstract: Social and economic activities, like religion, entertainment, education, research, and the production of other goods and services, are carried on by different types of organizations, for example, corporations, proprietorships, partnerships, mutuals and nonprofits. There is competition among organizational forms for survival. The form of organization that survives in an activity is the one that delivers the product demanded by customers at the lowest price while covering costs. The characteristics of residual claims are important both in distinguishing organizations from one another and in explaining the survival of organizational forms in specific activities. This paper develops a set of propositions that explain the special features of the residual claims of different organizational forms as efficient approaches to controlling agency problems.
Abstract: This paper analyzes the counterproductive effects associated with using budgets or targets in an organisation's performance measurement and compensation systems. Paying people on the basis of how their performance relates to a budget or target causes people to game the system and in doing so to destroy value in two main ways: (a) both superiors and subordinates lie in the formulation of budgets and, therefore, gut the budgeting process of the critical unbiased information that is required to coordinate the activities of disparate parts of an organisation, and (b) they game the realisation of the budgets or targets and in doing so destroy value for their organisations. Although most managers and analysts understand that budget gaming is widespread, few understand the huge costs it imposes on organisations and how to lower them. My purpose in this paper is to explain exactly how this happens and how managers and firms can stop this counter-productive cycle. The key lies not in destroying the budgeting systems, but in changing the way organisations pay people. In particular to stop this highly counter-productive behaviour we must stop using budgets or targets in the compensation formulas and promotion systems for employees and managers. This means taking all kinks, discontinuities and non-linearities out of the pay-for-performance profile of each employee and manager. Such purely linear compensation formulas provide no incentives to lie, or to withhold and distort information, or to game the system. While the evidence on the costs of these systems is not extensive, I believe that solving the problems could easily result in large productivity and value increases - sometimes as much as 50-100% improvements in productivity. I believe the less intensive reliance on such budget/target systems is an important cause of the increased productivity of entrepreneurial and LBO firms. Moreover, eliminating budget/target-induced gaming from the management system will eliminate one of the major forces leading to the general loss of integrity in organisations. People are taught to lie in these pervasive budgeting systems because if they tell the truth they often get punished and if they lie they get rewarded. Once taught to lie in this system people generally cannot help but extend that behaviour to all sorts of other relationships in the organisation.
Abstract: This paper analyzes the counterproductive effects associated with using budgets or targets in an organization's performance measurement and compensation systems. Paying people on the basis of how their performance relates to a budget or target causes people to game the system and in doing so to destroy value in two main ways: 1. both superiors and subordinates lie in the formulation of budgets and therefore gut the budgeting process of the critical unbiased information that is required to coordinate the activities of disparate parts of an organization, and 2. they game the realization of the budgets or targets and in doing so destroy value for their organizations. Although most managers and analysts understand that budget gaming is widespread, few understand the huge costs it imposes on organizations and how to lower them. My purpose in this paper is to explain exactly how this happens and how managers and firms can stop this counterproductive cycle. The key lies not in destroying the budgeting systems, but in changing the way organizations pay people. In particular to stop this highly counterproductive behavior we must stop using budgets or targets in the compensation formulas and promotion systems for employees and managers. This means taking all kinks, discontinuities and non-linearities out of the pay-for-performance profile of each employee and manager. Such purely linear compensation formulas provide no incentives to lie, or to withhold and distort information, or to game the system. While the evidence on the costs of these systems is not extensive, I believe that solving the problems could easily result in large productivity and value increases - sometimes as much as 50 to 100% improvements in productivity. I believe the less intensive reliance on such budget/target systems is an important cause of the increased productivity of entrepreneurial and LBO firms. Moreover, eliminating budget/target-induced gaming from the management system will eliminate one of the major forces leading to the general loss of integrity in organizations. People are taught to lie in these pervasive budgeting systems because if they tell the truth they often get punished and if they lie they get rewarded. Once taught to lie in this system people generally cannot help but extend that behavior to all sorts of other relationships in the organization. ----------- An executive summary of this paper entitled "Corporate Budgeting Is Broken, Let's Fix It", Harvard Business Review, pp. 94-101, November 2001, can be downloaded at no charge from Social Science Research Network Electronic Library at: http://papers.ssrn.com/paper=321520
Budgeting, Budgets, Compensation, Performance Measurement, Gaming, Lying, Loss of Integrity, Truthfulness, Sandbagging, Motivation, Productivity, Incentives, Control Systems, Accounting Irregularities, Fraud, Goldbricking, Channel Stuffing, Cooking the Books, Managing Earnings, Managing the Numbers
Abstract: Squeezing out excess capital and capacity is the most formidable challenge now facing the U.S. economy - and indeed, the economies of all industrialized nations. The author draws striking parallels between the 19th century industrial revolution and worldwide developments in the last two decades. In both periods, technological advances led to sharp increases in productivity and dramatic reductions in prices, but also to massive obsolescence and overcapacity. The great M&A wave of the 1890s consolidated some 1,800 firms into roughly 150. Similarly, the leveraged takeovers and LBOs of the 1980s provided healthy adjustments to the overcapacity that was building in many sectors of the U.S. economy. The author interprets the large shareholder gains from corporate restructurings as evidence of the failure of internal corporate control systems - managements and boards of directors - to deal voluntarily with the problem of excess capacity and asset redeployment. Reform of U.S. corporate governance is an urgent matter and should begin with significant equity ownership by managers and directors, greater participation by outside "active" investors, and smaller and better-informed boards.
Abstract: Since 1973 technological, political, regulatory, and economic forces have been changing the worldwide economy in a fashion comparable to the changes experienced during the nineteenth century Industrial Revolution. As in the nineteenth century, we are experiencing declining costs, increaing average (but decreasing marginal) productivity of labor, reduced growth rates of labor income, excess capacity, and the requirement for downsizing and exit. The last two decades indicate corporate internal control systems have failed to deal effectively with these changes, especially slow growth and the requirement for exit. The next several decades pose a major challenge for Western firms and political systems as these forces continue to work their way through the worldwide economy.
Productivity, technological change, excess capacity, exit, internal control systems, corporate control, R&D, research and development, industrial revolution, boards of directors, governance.
Abstract: A thorough understanding of internal incentive structures is critical to developing a viable theory of the firm, since these incentives determine to a large extent how individuals inside an organization behave. Many common features of organizational incentive systems are not easily explained by traditional economic theory--including egalitarian pay systems in which compensation is largely independent of performance, the overwhelming use of promotion-based incentive systems, the absence of up-front fees for jobs and effective bonding contracts, and the general reluctance of employers to fire, penalize, or give poor performance evaluations to employees. Typical explanations for these practices offered by behaviorists and practitioners are distinctly uneconomic--focusing on notions such as fairness, equity, morale, trust, social responsibility, and culture. The challenge to economists is to provide viable economic explanations for these practices or to integrate these alternative notions into the traditional economic model.
Abstract: We review some of the recent work in agency theory that has implications for the structure of the corporation, in particular the resolution of conflicts of interest among stockholders, managers, and creditors. We analyze the nature of residual claims and the separation of management and risk bearing in the corporation. This analysis provides a theory based on trade-offs of the risk sharing and other advantages of the corporate form with its agency costs to explain the survival of the corporate form in large-scale, complex, nonfinancial activities. We then discuss the structure of corporate bond, lease, and insurance contracts, and show how agency theory can be used to analyze contractual provisions for monitoring and bonding to help control the conflicts of interest between these fixed claimholders and stockholders.
Agency Theory, Conflicts Of Interest, Residual Claims, Bond Contracts, Lease Contracts, Insurance Contracts, Claimholders, Stockholders
Abstract: The publicly held corporation has outlived its usefulness in many sectors of the economy. New organizations are emerging. Takeovers, leveraged buyouts, and other going-private transactions are manifestations of this change. A central source of waste in the public corporation is the conflict between owners and managers over free cash flow. This conflict helps explain the prominent role of debt in the new organizations. The new organizations' resolution of the conflict explains how they can motivate people and manage resources more effectively than public corporations. (HBR McKinsey Award Winner)
Governance, Agency, Control, Organizational Innovation, Going Private, Control Function of Debt, LBO Associations
Abstract: There is an impressive body of empirical evidence which indicates that successive price changes in individual common stocks are very nearly independent. Recent papers by Mandelbrot and Samuelson show rigorously that independence of successive price changes is consistent with an efficient market, i.e., a market that adjusts rapidly to new information. It is important to note, however, that in the empirical work to date the usual procedure has been to infer market efficiency from the observed independence of successive price changes. There has been very little actual testing of the speed of adjustment of prices to specific kinds of new information. The prime concern of this paper is to examine the process by which common stock prices adjust to the information (if any) that is implicit in a stock split. In doing so we propose a new event study methodology for measuring the effects of actions and events on security prices.
efficient markets, effect of information on stock prices, stock splits, dividend increases, market conditions, rate of return, effect of split(s) on return(s), residuals, average dividends, dividend increases, and dividend decreases
Abstract: Our purpose in this paper is to examine divisional performance measurement methods and related aspects of the rules of the game that govern the behavior of managers. Performance measurement is one of the critical factors that determine how individuals in an organization behave. It is one aspect of what we call the organizational rules of the game, which consist of (1) the performance measurement and evaluation system, (2) the reward and punishment system, and (3) the system for partitioning decision rights among individuals in an organization. Performance measurement includes the objective and subjective assessments of the performance of both individuals and subunits of an organization such as divisions or departments. Performance evaluation is the process of attaching value weights to various measures of performance to represent the importance of achievement on each dimension. The reward and punishment system relates the rewards granted to individuals to results measured by the performance measurement system. Rewards and punishments include nonmonetary factors such as honor, attention, and rank, as well as monetary factors such as salary changes and bonuses. We analyze the peculiar characteristics of common divisional performance measures associated with what are often called cost centers, revenue centers, profit centers, investment centers and EVA and expense centers. We analyze the counterproductive incentives induced by these various performance measures and the conditions under which each of them could be sensibly used in an organization.
Abstract: This paper analyzes the relations between knowledge, control and organizational structure both in the market system as a whole and in private organizations. Limitations on the mental capacity of the human mind and the costs of producing and transferring knowledge means that knowledge relevant to all decisions can never be collected in the mind of a single individual or a small body of experts. This means that if the knowledge valuable to a particular decision is to be used in making that decision, there must be a system for partitioning out decision rights to individuals who already have the relevant knowledge and abilities or who can acquire or produce them at the lowest cost. Self interest on the part of individual decision-makers means a control system is required to motivate individuals with the decision rights and the relevant knowledge to use those decision rights appropriately. This control problem is solved in a capitalist economy by a system of alienable property rights.
Alienable rights cannot generally solve the control problem in firms, and the assignment of decision rights in firms does not generally include the assignment of alienability. Indeed, this is one of the major distinctions between firms and markets. The inalienability of rights within an organization means control problems must be solved by alternative means. Organizations solve these problems by establishing what we define to be the Organizational Rules of the Game that provide:
(1) a system for partitioning decision rights out to agents in the organization, (2) a performance measurement and evaluation system, and (3) a reward and punishment system
The inherent inefficiency of organizational control systems as compared to alienability means firms cannot survive unless they provide other offsetting advantages such as economies of scale, scope or riskbearing.
Abstract: CEOs are in a difficult bind with Wall Street. Managers up and down the hierarchy work hard at putting together plans and budgets for the next year and quite often when those plans are completed top management discovers that the results fall far below what Wall Street expects. CEOs and CFOs are therefore left in a difficult situation. They can stretch to try to meet Wall Street's expectations or prepare to be punished if they fail. All too often top managers react to the situation by encouraging or mandating middle and lower level managers to redo their forecasts, plans and budgets to get them in line with external expectations. In some cases, fearing the results of missing the Street's expectations, managers start the budgeting process with the consensus expectations and mandate that internal budgets and plans be set so as to meet them. Either way this sets the firm and its managers up for failure if external expectations are, in fact, impossible for the firm to meet. We illustrate, with the recent experience of Enron and Nortel, the dangers of conforming to market pressures for growth that are essentially impossible. We emphasize that an overvalued stock can be as damaging to the long-run health of a company as an undervalued stock, a proposition that few managers are familiar with. An overvalued stock sets in motion a variety of organizational behaviors that often end up damaging the firm. It does not have to be this way. Ending the expectations game requires that CEOs reclaim the initiative in terms of setting expectations and forecasts. To begin, CEOs must say no to the earnings guidance game and reverse recent practices in which analysts took the lead in driving industry forecasts, and companies complied. Managers must make their organizations more transparent to investors, so that stocks can trade at close to their intrinsic value. Doing so means CEOs and CFOs must inform the market when they believe the market expectations cannot be met and that the stock is, therefore, overvalued.
Value Maximization, Overvaluation, Incentives, Managing Earnings, Analyst Expectations, Managing Wall Street, Earnings Guidance, Financial Reporting, Budgeting Process
Abstract: Paying top executives better would eventually mean paying them more. The arrival of spring means yet another round in the national debate over executive compensation. Soon the business press will trumpet answers to the questions it asks every year: Who were the highest paid CEOs? How many executives made more than a million dollars? Who received the biggest raises? Political figures, union leaders, and consumer activists will issue now-familiar denunciations of executive salaries and urge that directors curb top-level pay in the interests of social equity and statesmanship. The critics have it wrong. There are serious problems with CEO compensation, but excessive pay is not the biggest issue. The relentless focus on how much CEOs are paid diverts public attention from the real problem--how CEOs are paid. In most publicly held companies, the compensation of top executives is virtually independent of performance. On average, corporate America pays its most important leaders like bureaucrats. Is it any wonder then that so many CEOs act like bureaucrats rather than the value-maximizing entrepreneurs companies need to enhance their standing in world markets? We recently completed an in-depth statistical analysis of executive compensation. Our study incorporates data on thousands of CEOs spanning five decades. The base sample consists of information on salaries and bonuses for 2,505 CEOs in 1,400 publicly held companies from 1974 through 1988. We also collected data on stock options and stock ownership for CEOs of the 430 largest publicly held companies in 1988. In addition, we drew on compensation data for executives at more than 700 public companies for the period 1934 through 1938.
Abstract: I define and analyze the agency costs of overvalued equity. They explain the dramatic increase in corporate scandals and value destruction in the last five years; costs that have totaled hundreds of billions of dollars. When a firm's equity becomes substantially overvalued it sets in motion a set of organizational forces that are extremely difficult to manage - forces that almost inevitably lead to destruction of part or all of the core value of the firm. WorldCom, Enron, Nortel, and eToys are only a few examples of what can happen when these forces go unmanaged. Because we currently have no simple solutions to the agency costs of overvalued equity this is a promising area for future research.
Abstract: I define and analyze the agency costs of overvalued equity. They explain the dramatic increase in corporate scandals and value destruction in the last five years; costs that have totaled hundreds of billions of dollars. When a firm's equity becomes substantially overvalued it sets in motion a set of organizational forces that are extremely difficult to manage - forces that almost inevitably lead to destruction of part or all of the core value of the firm. WorldCom, Enron, Nortel, and eToys are only a few examples of what can happen when these forces go unmanaged. Because we currently have no simple solutions to the agency costs of overvalued equity this is a promising area for future research. The first step in managing these forces lies in understanding the incongruous proposition that managers should not let their stock price get too high. By too high I mean a level at which management will be unable to deliver the performance required to support the market's valuation. Once a firm's stock price becomes substantially overvalued managers who wish to eliminate it are faced with disappointing the capital markets. This value resetting (what I call the elimination of overvaluation) is not value destruction because the overvaluation would disappear anyway. The resulting stock price decline will generate substantial pain for shareholders, board members, managers and employees, and this makes it difficult for managers and boards to short circuit the forces leading to value destruction. And when boards and managers choose to defend the overvaluation they end up destroying part or all of the core value of the firm. WorldCom, Enron, Nortel, and eToys are only a few examples of what can happen if these forces go unmanaged. Control markets cannot solve the problem because you cannot buy up an overvalued firm, eliminate the overvaluation and make money. Equity-based compensation cannot solve the problem because it makes the problem worse, not better. While it is puzzling that short selling was unable to resolve the problem the evidence seems to be consistent with the Shleifer and Vishny (1997) arguments for the limits of arbitrage. It appears the solution to these problems lies in the board of directors and the governance system. But that is a problem because there is substantial evidence that weak governance systems have failed widely. It also appears that boards and audit committees would be well served by communicating with and carefully evaluating the information that could be provided by short sellers of the firm's securities.
Overpriced Equity, Market Mistakes, Misvaluation, Faillure of Corporate Governance, Control, Incentives, optimism
Abstract: Considerable attention has recently been given to general equilibrium models of the pricing of capital assets. Of these, perhaps the best known is the mean-variance formulation originally developed by Sharpe (1964) and Treynor (1961), and extended and clarified by Lintner (1965a; 1965b), Mossin (1966), Fama (1968a; 1968b), and Long (1972). In addition Treynor (1965), Sharpe (1966), and Jensen (1968; 1969) have developed portfolio evaluation models which are either based on this asset pricing model or bear a close relation to it. In the development of the asset pricing model it is assumed that (1) all investors are single period risk-averse utility of terminal wealth maximizers and can choose among portfolios solely on the basis of mean and variance, (2) there are no taxes or transactions costs, (3) all investors have homogeneous views regarding the parameters of the joint probability distribution of all security returns, and (4) all investors can borrow and lend at a given riskless rate of interest. The main result of the model is a statement of the relation between the expected risk premiums on individual assets and their "systematic risk." Our main purpose is to present some additional tests of this asset pricing model which avoid some of the problems of earlier studies and which, we believe, provide additional insights into the nature of the structure of security returns. The evidence presented in Section II indicates the expected excess return on an asset is not strictly proportional to its B, and we believe that this evidence, coupled with that given in Section IV, is sufficiently strong to warrant rejection of the traditional form of the model given by (1). We then show in Section III how the cross-sectional tests are subject to measurement error bias, provide a solution to this problem through grouping procedures, and show how cross-sectional methods are relevant to testing the expanded two-factor form of the model. We show in Section IV that the mean of the beta factor has had a positive trend over the period 1931-65 and was on the order of 1.0 to 1.3% per month in the two sample intervals we examined in the period 1948-65. This seems to have been significantly different from the average risk-free rate and indeed is roughly the same size as the average market return of 1.3 and 1.2% per month over the two sample intervals in this period. This evidence seems to be sufficiently strong enough to warrant rejection of the traditional form of the model given by (1). In addition, the standard deviation of the beta factor over these two sample intervals was 2.0 and 2.2% per month, as compared with the standard deviation of the market factor of 3.6 and 3.8% per month. Thus the beta factor seems to be an important determinant of security returns.
capital asset pricing, measurements, Cross-sectional Tests, Two-Factor Model, aggregation problem
Abstract: This paper reviews much of the scientific literature on the market for corporate control. The evidence indicates that corporate takeovers generate positive gains, that target firm shareholders benefit, and that bidding firm shareholders do not lose. The gains created by corporate takeovers do not appear to come from the creation of market power. With the exception of actions that exclude potential bidders, it is difficult to find managerial actions related to corporate control that harm shareholders. Finally, we argue the market for corporate control is best viewed as an arena in which managerial teams compete for the rights to manage corporate resources.
Corporate control, managing corporate resources, control rights, target firms, takeover market, wealth effects of takeovers, stockholder returns, returns to targets, returns to bidders, antitrust, takeover regulation, manager-stockholder conflict(s), antitakeover amendments.
Abstract: Our purpose is to provide a review of the development of the modern theory of corporate finance. Through the early 1950s the finance literature consisted in large part of ad hoc theories. Dewing (1919; 1953) the major corporate finance textbook for a generation, contains much institutional detail but little systematic analysis. It starts with the birth of a corporation and follows it through various policy decisions to its death (bankruptcy). Corporate financial theory prior to the 1950s was riddled with logical inconsistencies and was almost totally prescriptive, that is, normatively oriented. The major concerns of the field were optimal investment, financing, and dividend policies, but little consideration was given to the effect on these policies of individual incentives, or to the nature of equilibrium in financial markets. The logical structure of decision-making implies that better answers to normative questions are likely to occur when the decision maker has a richer set of positive theories that provide a better understanding of the consequences of his or her choices. This important relation between normative and positive theories often goes unrecognized. Purposeful decisions cannot be made without the explicit or implicit use of positive theories. You cannot decide what action to take and expect to meet your objective if you have no idea about how alternative actions affect the desired outcome - and that is what is meant by a positive theory. For example, to choose among alternative financial structures, a manager wants to know how the choices affect expected net cash flows, their riskiness, and therefore how they affect firm value. Using incorrect positive theories leads to decisions that have unexpected and undesirable outcomes. In reviewing the development of the theory of corporative finance we begin in Section 2 with a brief summary of the major theoretical building blocks of financial economics. The major areas of corporate financial policy - capital budgeting, capital structure, and dividend policy - are discussed in Sections 3 through 5.
Abstract: Our estimates of the pay-performance relation (including pay, options, stockholdings, and dismissal) for chief executive officers indicate that CEO wealth changes $3.25 for every $1,000 change in shareholder wealth. Although the incentives generated by stock ownership are large relative to pay and dismissal incentives, most CEOs hold trivial fractions of their firms' stock, and ownership levels have declined over the past 50 years. We hypothesize that public and private political forces impose constraints that reduce the pay-performance sensitivity. Declines in both the pay-performance relation and the level of CEO pay since the 1930s are consistent with this hypothesis.
Abstract: In Coordination, Control, and the Management of Organizations (CCMO) we periodically hand out an abbreviated set of course notes to students that follow reasonably closely the class schedule and discussions in the first half of the course. The notes are designed to help students organize the main points of the class discussions and their own notes, and are not intended to be a stand-alone text (although that project is underway). These notes were first created in the mid-1970s by Jensen and Meckling for use in their CCMO course at the Rochester's Simon School of Business. Three faculty at Rochester involved in the course have published a written and somewhat supplemented version of the Course Notes as they were left in 1989 on Jensen's departure from Rochester. The notes have continued to evolve over time with the course and with the contributions of fellow teaching faculty George P. Baker and Karen H. Wruck. We hand out the notes in two parts after we have completed discussion of the material. We have found that class discussions and learning are vastly improved if the notes are available to the students only after they have read and discussed the material. We ask students not to use notes from past semesters, to treat the notes in the same way they would treat information from fellow students in an earlier class or in an exam and not to distribute the notes to others. ----------- The CCMO materials are presented in four electronic documents entitled as follows (you can go directly to each document and its abstract by clicking on the title below): 1. Organizations and Markets: History and Development of the Course and the Field, by Michael C. Jensen, George P. Baker, Carliss Y. Baldwin, and Karen H. Wruck, Dec. 10, 1997 (forthcoming in "The Intellectual Venture Capitalist: John H. McArthur and the Work of the Harvard Business School," 1980-1995, Thomas K. McCraw and Jeffrey L. Cruickshank, eds, (Harvard Business School Press, 1998)). 2. This document -- Coordination, Control, and the Management of Organizations: Course Notes, by Michael C. Jensen and William H. Meckling, with contributions from George P. Baker and Karen H. Wruck, April 20, 1998, Harvard Business School Working Paper. 3. Coordination, Control, and the Management of Organizations: Course Content and Materials, by Michael C. Jensen and Karen H. Wruck, April 20, 1998, unpublished manuscript, Harvard Business School. 4. Coordination, Control, and the Management of Organizations: Practice Questions, by Michael C. Jensen, William H. Meckling, George P. Baker, and Karen H. Wruck, with contributions from Carliss Y. Baldwin, and Malcolm S. Salter, April 20, 1998, unpublished manuscript, Harvard Business School. Return to main CCMO abstract.
Abstract: There are three main elements in an organization's total strategy: its competitive strategy, its organization strategy, and its human strategy. This volume contains twelve articles written over the last twenty-five years which deal with a firm's organizational strategy. In these articles my co-authors (noted in each chapter) and I lay out the foundations of a theory of organizations that is both integrated and powerful. The development of this material had its genesis in the early 1970s at the University of Rochester, where two complementary initiatives spurred this effort. One was the research that William Meckling and I began on agency theory in 1973, which opened up a new set of insights into the behavior of managers and firms. The second was the course development effort that Meckling and I began at the same time, which has led to major courses at both Rochester and Harvard. In our course at Harvard Business School, entitled Coordination, Control, and the Management of Organizations (CCMO), my colleagues (George Baker, Carliss Baldwin, Karen Wruck, and Malcolm Salter) and I apply the concepts to a wide range of management and organizational problems. The course, one of the most successful in the second year of the MBA program, attracts about 600 students each year. The history of the course is summarized in Organizations and Markets at the Harvard Business School, 1984-1996 by Michael C. Jensen, George Baker, Carliss Baldwin, and Karen H. Wruck, in The Intellectual Venture Capitalist: John H. McArthur and the Work of Harvard Business School 1980-1995, edited by Thomas K. McCraw and Jeffrey L. Cruikshank (Harvard Business School Press, 1998). This article and a complete description of the CCMO course, including the course syllabus, reading list, course notes, and practice questions, are available in four electronic documents on the Internet from the Social Science Research Network Electronic Library at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=58704.
organizations, REMM, PAM, nature of man, specific knowledge, general knowledge, transfer of knowledge, control systems
Abstract: The foundations are being put in place for a revolution in the science of organizations. Some major analytical building blocks for the development of a theory of organizations are outlined and discussed in this paper. This development of organization theory will be hastened by increased understanding of the importance of the choice of definitions, tautologies, analytical techniques, and types of evidence. The two literatures of agency theory are briefly discussed in light of these issues. Because accounting is an integral part of the structure of every organization, the development of a theory of organizations will be closely associated with the development of a theory of accounting. This theory will explain why organizations take the form they do, why they behave as they do, and why accounting practices take the form they do. Because such positive theories as these are required for purposeful decision making, their development will provide a better scientific basis for the decisions of managers, standard-setting boards, and government regulatory bodies.
Abstract: This article analyzes Total Quality Management as an innovation in organizational technology that can be used by companies to increase the productivity of both labor and capital. As an organizing technology, TQM has three distinguishing features: (1) it is science-based in the sense that individuals at all levels of the organization are trained to use scientific method in everyday decision-making; (2) it is non-hierarchical insofar as it provides a process for decentralizing decision-making in ways that do not correspond to the traditional corporate hierarchy; (3) it is non-market-oriented in that it does not use prices or formal exchange mechanisms, such as transfer pricing systems, to motivate cooperation or the transfer of decision rights.
Despite the potential benefits of TQM, and the many TQM success stories, there is also considerable testimony to the difficulty of establishing and maintaining effective TQM programs. We suggest that one important source of TQM's implementation problems has been the failure to develop a systematic approach to identifying the entire set of organizational changes required by a comprehensive TQM program.
While typically arising out of a concern for product quality, the most successful TQM programs end up becoming efficiency improvement initiatives that involve organization-wide changes in decision-making authority and performance measures. For this reason, effective implementation of TQM requires major changes in all three components of what we refer to collectively as the organizational rules of the game--that is, not only (1) systems for allocating decision rights and (2) performance measurement systems, but also (3) reward and punishment systems. Unlike those quality advocates like Edward Deming who object to the use of monetary incentives to reinforce TQM initiatives, we argue that "the increased decentralization associated with TQM should be associated with a strengthening of the relation between performance and rewards of all types."
Note: This paper draws heavily on our Journal of Accounting and Economics paper of the same title, Volume 18, 1994, pp. 247-287. See the working paper version of this paper "Science, Specific Knowledge, and Total Quality Management".
Abstract: We analyze Total Quality Management (TQM) from an economic and organizational perspective. We find that TQM is a new organizing technology that is science-based, non-hierarchical, and non-market-oriented. It improves productivity by encouraging the use of science in decision-making and discouraging counter-productive defensive behavior. It also encourages effective creation and use of specific knowledge throughout the organization. Effective implementation of TQM generally requires major changes in all three components of the organizational rules of the game, namely systems for allocating decision rights, performance measurement systems, and reward and punishment systems. Note: A revised and shortened version of this paper is published under the same title in the Journal of Applied Corporate Finance, Summer 1997, Vol. 10, No 2. You can download it at: "Science, Specific Knowledge, and Total Quality Management".
Abstract: Through dozens of studies, economists have accumulated considerable evidence and knowledge on the effects of the takeover market. Most of the earlier work is well summarized elsewhere (Jensen and Ruback (1983); Jensen (1984); Jarrell, Brickley and Netter (1988)). Here, I focus on current aspects of the controversy. In brief, the previous work tells us the following: Takeovers benefit shareholders of target companies. Premiums in hostile offers historically exceed 30 percent on average, and in recent times have averaged about 50 percent. Acquiring-firm shareholders on average earn about 4 percent in hostile takeovers and roughly zero in mergers, although these returns seem to have declined from past levels. Takeovers do not waste credit or resources. Instead, they generate substantial gains: historically, 8 percent of the total value of both companies. Actions by managers that eliminate or prevent offers or mergers are most suspect as harmful to shareholders. Golden parachutes for top-level managers do not, on average, harm shareholders. The activities of takeover specialists (such as Icahn, Posner, Steinberg, and Pickens) benefit shareholders on average. Merger and acquisition activity has not increased industrial concentration. Over 1200 divestitures valued at $59.9 billion occurred in 1986, also a record level (Grimm, 1986). Takeover gains do not come from the creation of monopoly power. Although measurement problems make it difficult to estimate the returns to bidders as precisely as the returns to targets, it appears the bargaining power of target managers, coupled with competition among potential acquirers, grants a large share of the acquisition benefits to selling shareholders. In addition, federal and state regulation of tender offers appears to have strengthened the hand of target firms; premiums received by target-firm shareholders increased substantially after introduction of such regulation.
Dividend policy, Corporate Payout Policy, Optimal Capital Structure, Optimal Debt, Reivestment Policy, Overinvestmen
Abstract: In this paper we provide a new definition of leadership that gives organizations and individuals access to new power. In our model, leadership consists of four critical elements: -- The creation of a vision for the future that represents a significant departure from the past, one that requires breakthroughs for its realization. -- The creation of a system that facilitates enrollment into and elicits voluntary commitment to the vision by the critical mass of people required to discover and implement the breakthroughs required for realization of the vision. -- The creation of a system that ensures both the timely identification of breakdowns and the dissemination of information about them that, if unresolved, would prevent the successful realization of the vision -- The creation of a system for managing breakdowns that causes people to voluntarily recommit to the vision and maintain these commitments through to the implementation of the breakthroughs required for the realization of the vision We give examples, from both large and small companies to illustrate our principles and advice for putting these principles into action.
leadership, management, breakthrough, breakdown, innovation, commitment
Abstract: This paper describes the history of the development of the course Coordination, Control and the Management of Organizations (CCMO) from its initiation by Michael C. Jensen and William H. Meckling at the University of Rochester in 1973 to its current state as one of the most highly demanded elective courses in the second year of the MBA program at Harvard Business School. CCMO regularly attracts between 500 and 600 of the 850 second-year MBA students. CCMO presents a new theory of organizations that draws on economics, finance, psychology, neuroscience, and human resource management. In developing our theory, we focus particularly on four interrelated areas: 1) the nature of human beings and their behavior; 2) compensation, career systems, and performance measurement; 3) task structure, organizational boundaries, and technology; and 4) governance, corporate finance, and organizational performance. This paper presents specifics in each of these four categories. (Forthcoming in The Intellectual Venture Capitalist: John H. McArthur and the Work of the Harvard Business School, 1980-1995, Edited by Thomas K. McCraw and Jeffrey L. Cruikshank, Harvard Business School Press, 1998.) ----------- The CCMO materials are presented in four electronic documents entitled as follows (you can go directly to each document and its abstract by clicking on the title below): 1. This document -- Organizations and Markets: History and Development of the Course and the Field, by Michael C. Jensen, George P. Baker, Carliss Y. Baldwin, and Karen H. Wruck, Dec. 10, 1997 (forthcoming in "The Intellectual Venture Capitalist: John H. McArthur and the Work of the Harvard Business School," 1980-1995, Thomas K. McCraw and Jeffrey L. Cruickshank, eds, (Harvard Business School Press, 1998)). 2. Coordination, Control, and the Management of Organizations: Course Notes, by Michael C. Jensen and William H. Meckling, with contributions from George P. Baker and Karen H. Wruck, April 20, 1998, Harvard Business School Working Paper. 3. Coordination, Control, and the Management of Organizations: Course Content and Materials, by Michael C. Jensen and Karen H. Wruck, April 20, 1998, unpublished manuscript, Harvard Business School. 4. Coordination, Control, and the Management of Organizations: Practice Questions, by Michael C. Jensen, William H. Meckling, George P. Baker, and Karen H. Wruck, with contributions from Carliss Y. Baldwin, and Malcolm S. Salter, April 20, 1998, unpublished manuscript, Harvard Business School. Return to main CCMO abstract.
Abstract: This paper analyzes the counterproductive effects associated with using budgets or targets in an organization's performance measurement and compensation systems. Paying people on the basis of how their performance relates to a budget or target causes people to game the system and in doing so to destroy value in two main ways: 1. both superiors and subordinates lie in the formulation of budgets and therefore gut the budgeting process of the critical unbiased information that is required to coordinate the activities of disparate parts of an organization, and 2. they game the realization of the budgets or targets and in doing so destroy value for their organizations. Although most managers and analysts understand that budget gaming is widespread, few understand the huge costs it imposes on organizations and how to lower them. My purpose in this paper is to explain exactly how this happens and how managers and firms can stop this counterproductive cycle. The key lies not in destroying the budgeting systems, but in changing the way organizations pay people. In particular to stop this highly counterproductive behavior we must stop using budgets or targets in the compensation formulas and promotion systems for employees and managers. This means taking all kinks, discontinuities and non-linearities out of the pay-for-performance profile of each employee and manager. Such purely linear compensation formulas provide no incentives to lie, or to withhold and distort information, or to game the system. While the evidence on the costs of these systems is not extensive, I believe that solving the problems could easily result in large productivity and value increases - sometimes as much as 50 to 100% improvements in productivity. I believe the less intensive reliance on such budget/target systems is an important cause of the increased productivity of entrepreneurial and LBO firms. Moreover, eliminating budget/target-induced gaming from the management system will eliminate one of the major forces leading to the general loss of integrity in organizations. People are taught to lie in these pervasive budgeting systems because if they tell the truth they often get punished and if they lie they get rewarded. Once taught to lie in this system people generally cannot help but extend that behavior to all sorts of other relationships in the organization. ----------- This paper is an executive summary of a longer paper entitled "Paying People to Lie: The Truth About the Budgeting Process" that can be downloaded at no charge from Social Science Research Network Electronic Library at: http://papers.ssrn.com/paper=267651
Abstract: This article surveys the seventeen papers in this special issue of the Journal of Financial Economics, and related work. The major findings are: (1) patterns of stock ownership by insiders and outsiders can influence managerial behavior, corporate performance, and stockholder voting in election contests; (2) corporate leverage, inside stock ownership by managers, and the control market are interrelated; (3) departures from one share/one vote affect firm value and efficiency; (4) takeover resistance through defensive restructurings or poison pill provisions is associated with declines in share price; and (5) top management turnover is inversely related to share price performance.
Agency Costs, Managerial Stock Ownership, Insiders, Outsiders, Control Market, Corporate Performance, One Share/One Vote, Restructuring, Poison Pill Provisions, Performance
Abstract: This document contains a collection of 99 exam questions from the last 20 years of the Coordination, Control, and the Management of Organizations (CCMO) course. They are given to students at the end of the semester as a vehicle to aid their study for the final exam. These questions are a combination of stand-alone questions and questions that accompany journal and magazine articles. They are organized with the most recent exam questions last, so we recommend that readers start from the last questions and move toward the front of the document in their study. ----------- The CCMO materials are presented in four electronic documents entitled as follows (you can go directly to each document and its abstract by clicking on the title below): 1. Organizations and Markets: History and Development of the Course and the Field, by Michael C. Jensen, George P. Baker, Carliss Y. Baldwin, and Karen H. Wruck, Dec. 10, 1997 (forthcoming in "The Intellectual Venture Capitalist: John H. McArthur and the Work of the Harvard Business School," 1980-1995, Thomas K. McCraw and Jeffrey L. Cruickshank, eds, (Harvard Business School Press, 1998)). 2. Coordination, Control, and the Management of Organizations: Course Notes, by Michael C. Jensen and William H. Meckling, with contributions from George P. Baker and Karen H. Wruck, April 20, 1998, Harvard Business School Working Paper. 3. Coordination, Control, and the Management of Organizations: Course Content and Materials, by Michael C. Jensen and Karen H. Wruck, April 20, 1998, unpublished manuscript, Harvard Business School. 4. This document -- Coordination, Control, and the Management of Organizations: Practice Questions, by Michael C. Jensen, William H. Meckling, George P. Baker, and Karen H. Wruck, with contributions from Carliss Y. Baldwin, and Malcolm S. Salter, April 20, 1998, unpublished manuscript, Harvard Business School. Return to main CCMO abstract.
Abstract: Commencement Address given to the University of Toronto, June 15, 2005. In this talk I enumerate and briefly discuss eleven commitments that form the foundations of an extraordinary life and of leadership. They range from a commitment to a never-ending search for truth, a willingness to delay gratification, to a recognition that since success breeds failure managing success is a difficult challenge.
Leadership, Extraordinary Life, Principles for Living, Success,
Abstract: The takeover boom of the 1980s challenged entrenched corporate management, who since the 1930s held the reins of corporate decision-making, often at the expense of shareholder interests. The effect was to transfer control over vast corporate resources to smaller, more focused and in many cases private corporations and individuals, who returned huge amounts of equity capital to shareholders. This accomplished the freeing of resources long trapped in mature industries and uneconomic conglomerates. The popular media's stories about this phenomenon differ markedly from the stories told by careful academic research. We examine these stories, the political reactions to them, and the economic effects of the reactions. We also evaluate the effect of corporate restructuring on capital investment and R&D. We explain the phenomenon of excess capacity, and the forces that lead to exit. Finally, we analyze the breakdown of internal control systems and make recommendations to strengthen them.
Takeovers, LBOs, leveraged buyouts, politics of finance, corporate restructuring, entrenched management, excess capacity, internal control systems, exit
Abstract: The course Coordination, Control and the Management of Organizations (CCMO) develops a theory of organizations that provides a clear understanding of how organizational "rules of the game" affect a manager's ability to resolve problems, increase productivity, and achieve his or her objective. The course explores the choice of the organizational objective function and the value implications for equity and debt holders, employees, suppliers and society as a whole. The viewpoint of the course is that of a general manager addressing organizational strategy with an internal rather than an external focus. The analysis emphasizes the constraints that external markets, such as capital, supplier, labor, and product markets, place on a firm's internal organizational strategy. The framework developed is analytical, but not mathematical. It provides an understanding of how organizational structure affects performance and how current economic and social forces are reshaping the role of managers, both today and in the future. This documents contains I. CCMO Course Description II. CCMO Course Syllabus III. CCMO Course Reading List, a complete session-by-session reading list for a 35 session version of the course. IV. CCMO Assignment Questions, a complete set of session by session assignment questions for a 35 session version of the course. ----------- The CCMO materials are presented in four electronic documents entitled as follows (you can go directly to each document and its abstract by clicking on the title below): 1. Organizations and Markets: History and Development of the Course and the Field, by Michael C. Jensen, George P. Baker, Carliss Y. Baldwin, and Karen H. Wruck, Dec. 10, 1997 (forthcoming in "The Intellectual Venture Capitalist: John H. McArthur and the Work of the Harvard Business School," 1980-1995, Thomas K. McCraw and Jeffrey L. Cruickshank, eds, (Harvard Business School Press, 1998)). 2. Coordination, Control, and the Management of Organizations: Course Notes, by Michael C. Jensen and William H. Meckling, with contributions from George P. Baker and Karen H. Wruck, April 20, 1998, Harvard Business School Working Paper. 3. This document -- Coordination, Control, and the Management of Organizations: Course Content and Materials, by Michael C. Jensen and Karen H. Wruck, April 20, 1998, unpublished manuscript, Harvard Business School. 4. Coordination, Control, and the Management of Organizations: Practice Questions, by Michael C. Jensen, William H. Meckling, George P. Baker, and Karen H. Wruck, with contributions from Carliss Y. Baldwin, and Malcolm S. Salter, April 20, 1998, unpublished manuscript, Harvard Business School. Return to main CCMO abstract.
Abstract: Presented at the Harvard Business School Centennial Conference on Private Equity, New York City, Feb. 13, 2007; the Swedish Institute for Financial Research Conference on The Economics of the Private Equity Market, Stockholm, Sweden, Aug. 30, 2007; American Enterprise Institute Conference on The History, Impact, and Future of Private Equity Ownership, Governance, and Firm Performance, Washington, DC, Nov. 27, 2007.
Note: SSRN is experimenting with enabling the distribution of different types of files: slides, spreadsheets, video, etc. We are interested in our users desires to distribute files that go beyond word processing text files. You can communicate with me on these issues via my email address below. We invite you to submit your own presentation slides.
Private Equity funds have grown from a tiny part of the financial market in the early 1980s to an important global force today. Morgan Stanley estimated in 2007 that 2,700 Private equity funds represented 25% of global mergers and acquisition activity, 50% of leverage loan volume, 33% of the high yield bond market, and 33% of the initial public offerings market.
I present in these slides my belief, first argued in my 1989 Harvard Business Review paper entitled The Eclipse of the Public Corporation that Private Equity is best thought of as a new and powerful model of General Management. I also summarize some important characteristics of Private Equity that contribute to value creation, how Private Equity generally implements Strategic Value Accountability (what I have labelled the missing concept in corporate governance) much better than the public corporation, and how Private Equity avoids much of the out-of-integrity gaming and lying that dominates the relations between public firms and capital markets. I close by summarizing some growing problematical trends and practices that threaten the success of this new business model and the future of the Private Equity industry (in particular the threat posed by the proliferation of non-equity based fees charged by Private Equity firms, and the going public of the core management private equity company such as that by Fortress and Blackstone and the raising of permanent public capital to substitute for the non-permanent limited partnership capital such as that by KKR in Europe).
Private Equity, LBOs, MBOs, Buyouts, Strategic Value Accountability
Abstract: This paper analyzes investment rules for various organizational forms that are distinguished by the characteristics of their residual claims. Different restrictions on residual claims lead to different decision rules. The analysis indicates that the investment decisions of open corporations, financial mutuals and nonprofits can be modeled by the value maximization rule. However, the decisions of proprietorships, partnerships, and closed corporations cannot in general be modeled by the market value rule.
organizational forms, investment, proprietorships, partnerships, closed corporations, market value rule, residual claims, open corporations
Abstract: Note: SSRN is experimenting with enabling the distribution of different types of files: slides, spreadsheets, video, etc. We are interested in our users desires to distribute files that go beyond word processing text files. You can communicate with Michael Jensen on these issues via his email address below. SSRN invites you to submit your own presentation slides.
We present a positive model of integrity that, as we distinguish and define integrity, provides powerful access to increased performance for individuals, groups, organizations, and societies. Our model reveals the causal link between integrity and increased performance, quality of life, and value-creation for all entities, and provides access to that causal link. Integrity is thus a factor of production as important as knowledge and technology, yet its major role in productivity and performance has been largely hidden or unnoticed, or even ignored by economists and others.
The philosophical discourse, and common usage as reflected in dictionary definitions, leave an overlap and confusion among the four phenomena of integrity, morality, ethics, and legality. This overlap and confusion confound the four phenomena so that the efficacy and potential power of each is seriously diminished.
In this new model, we distinguish all four phenomena - integrity, morality, ethics, and legality - as existing within two separate realms. Integrity exists in a positive realm devoid of normative content. Integrity is thus not about good or bad, or right or wrong, or what should or should not be. Morality, ethics and legality exist in a normative realm of virtues (that is, they are about good and bad, right and wrong, or what should or should not be). Furthermore, within their respective realms, each of the four phenomena is distinguished as belonging to a distinct and separate domain, and the definition of each as a term is made clear, unambiguous, and non-overlapping.
We distinguish the domain of integrity as the objective state or condition of an object, system, person, group, or organizational entity, and, consistent with the first two of the three definitions in Webster's dictionary, define integrity as a state or condition of being whole, complete, unbroken, unimpaired, sound, perfect condition.
We assert that integrity (the condition of being whole and complete) is a necessary condition for workability, and that the resultant level of workability determines the available opportunity for performance. Hence, the way we treat integrity in our model provides an unambiguous and actionable access to the opportunity for superior performance, no matter how one defines performance.
For an individual we distinguish integrity as a matter of that person's word being whole and complete. For a group or organizational entity we define integrity as that group' or organization's word being whole and complete. A group's or organization's word consists of what is said between the people in that group or organization, and what is said by or on behalf of the group or organization. In that context, we define integrity for an individual, group, or organization as: honoring one's word.
Oversimplifying somewhat, "honoring your word", as we define it, means you either keep your word, or as soon as you know that you will not, you say that you will not be keeping your word to those who were counting on your word and clean up any mess you caused by not keeping your word. By "keeping your word" we mean doing what you said you would do and by the time you said you would do it.
Honoring your word is also the route to creating whole and complete social and working relationships. In addition, it provides an actionable pathway to earning the trust of others.
We demonstrate that the application of cost-benefit analysis to honoring your word guarantees that you will be untrustworthy. And that, with one exception, you will not be a person of integrity, thereby reducing both the workability of your life and your opportunity for performance. The one exception to this form of being out of integrity is, if when giving your word you have announced that you will apply cost-benefit analysis to honoring your word. In this case you have maintained your integrity, but you have also announced that you are an unmitigated opportunist. The virtually automatic application of cost-benefit analysis to one's integrity (an inherent tendency in most of us) lies at the heart of much out-of-integrity and untrustworthy behavior in modern life.
Regarding the relationship between integrity, and the three virtue phenomena of morality, ethics and legality, this new model: 1) encompasses all four terms in one consistent theory, 2) makes clear and unambiguous the "moral compasses" potentially available in each of the three virtue phenomena, and 3) by revealing the relationship between honoring the standards of the three virtue phenomena and performance (including being complete as a person and the quality of life), raises the likelihood that the now clear moral compasses can actually shape human behavior. This all falls out primarily from the unique treatment of integrity in our model as a purely positive phenomenon, independent of normative value judgments.
In summary, we show that defining integrity as honoring one's word (as we have defined "honoring one's word"): 1) provides an unambiguous and actionable access to the opportunity for superior performance and competitive advantage at both the individual and organizational level, and 2) empowers the three virtue phenomena of morality, ethics and legality.
PDF file of Keynote slides for seminars at the Gruter Institute Conference on Values, Harvard Business School, June 2006; Simon School of Business, U. of Rochester; Fisher College of Business, Ohio State University, Columbus, OH, Sept. 2006, Nottingham College of Business, Nottingham, UK, ESADE Business School, Barcelona, Spain; HEC, Paris, France, Nov. 2006, Yale Symposium on Corporate Governance, Inaugural Lecture, (Yale Law School and Yale School of Organization and Management), New Haven, CT, January 2007, Gruter Institute Squaw Valley Conference: Law, Brain and Behavior, May 2007, Harvard Business School Negotiations Organizations and Markets Seminar, Sept. 2007; Yale School of Management, Sept. 2007: MIT Sloan School of Management Leadership Center, Cambridge, MA, Oct. 2007; Harvard Law School Law, Economics and Organizations Research Seminar, Cambridge, MA, Oct. 2007; USC Marshall School of Business, Finance and Economics Dept. Distinguished Speaker Series, Nov. 2007; LeBow College Corporate Governance Conference, Philadelphia, PA, April 2008; Special Seminar Series, Business Department, Juan Carlos III University, Madrid, Spain, April, 2008; Herbert Simon Lecture, Rajk Laszlo College, Corvinus University of Budapest, Budapest, Hungary, April 21, 2008; Exeter at Said Business School, Oxford, UK, April 24, 2008; U. of Rochester Simon School of Business Alumni Seminar, NYC, May 5, 2008; DePaul U. Kellstdat School of Business, Chicago, IL, May 8, 2008; 1st IESE Conference on Humanizing the Firm and the Management Profession, IESE Business School, Barcelona, Spain, July 2, 2008 Stern Stewart International Finance Summit, Cape Town, South Africa, July 31, 2008; Concordia University John Molson School of Business, Montreal, Quebec, CA Sept. 16, 2008; Institute of Corporate Directors Conference on Governance and Financial Markets in North America, Montreal, Quebec, CA, Sept. 19, 2008; Duisenberg School of Finance, Amsterdam, Netherlands, Oct. 14, 2008; Paduano Faculty Research Symposium in Business Ethics, Stern School of Business, New York, Oct. 23, 2008; Olin School of Business Faculty Forum Sponsored by the Center for Research in Economics and Strategy and the Center for the Study of Ethics and Human Values, Washingtoe University, St. Louis, MO, Nov. 6, 2008; Fisher School of Business, Ohio State U., Columbus, OH, Nov. 7, 2008; United States Air Force Academy, Platinum Series, Colorado Springs, CO, Jan. 21, 2009; Texas A&M Distinguished Lecture Series, College Station, TX, Feb. 10, 2009; Social Innovation Research Seminar Series, INSEAD, Fontainebleau, France, March 16, 2009.
Integrity, Morality, Ethics, Legality, Sincerity, Productivity, Performance, Lies, Lying, Managing Earnings, Smoothing Earnings, Collusion, Development, Disclosure Strategy, Fiduciary Responsibility, Financial Reporting, Accounting Errors, Fraud, Corporate Governance
Abstract: The recent wave of corporate scandals provides continuing evidence that boards have failed to fulfill their role as the top-level corporate control mechanism. Destroyed companies, ruined reputations and in some cases jail sentences have created an environment in which substantial changes in the role of the board may occur. To solve the problems boards must change fundamentally their approach to the job. We recommend that boards focus on the following areas: - Be clear about the decision rights and role of the board - being careful to see that the board holds and exercises the top-level control rights in the organization, including the rights to initiate and implement decisions such as the right to hire, evaluate, compensate, and fire the top management team, board members, and the auditors. - Change the structural, social, psychological and power environment of the board so that board members are no longer effectively the employees of the CEO. - Change the philosophical mindset of the board from one of careful review and compliance to one of insatiable curiosity and clarity. - Take seriously the role of the board as the body ultimately responsible for ensuring the integrity of the organization in all matters. This means individual board members must come to understand and institutionalize the notion that honesty and integrity in our actions and our words are most valuable to others when it costs us something to adhere to them. Yet we tend to forgive ourselves the obligation to uphold these values in exactly those situations where there are high costs (whether monetary, psychological, and/or reputational) to ourselves, the CEO and others, or the company. Restoring integrity to the system will require men and women of courage and conviction on boards and in management teams to incur costs in the short run to preserve their reputations and the reputation and value of the organizations they serve.
Abstract: The market for corporate control is fundamentally changing the corporate landscape. Transactions in this market in 1985 were at a record level of $180 billion. These transactions involve takeovers, mergers, and leveraged buyouts. Closely associated are corporate restructurings involving divestitures, spinoffs, and large stock repurchases for cash and debt. The changes associated with these control transactions are causing considerable controversy. Some argue that takeovers are damaging to the morale and productivity of organizations and are therefore damaging to the economy. Others argue that takeovers represent productive entrepreneurial activity that improves the control and management of assets and helps move assets to more productive uses. The controversy has been accompanied by strong pressure on regulators and legislatures to enact restrictions that would curb activity in the market for corporate control. In the spring of 1985 there were over 20 bills under consideration in Congress that proposed new restrictions on takeovers. Within the past several years the legislatures of New York, New Jersey, Maryland, Pennsylvania, Connecticut, Illinois, Kentucky, and Michigan has passed antitakeover laws. The Federal Reserve Board entered the fray early in 1986 when it issued its controversial new interpretation of margin rules that restricts the use of debt in society. This paper analyzes the controversy surrounding takeovers and provides both theory and evidence to explain the central phenomena at issue. The paper is organized as follows. Section 2 contains basic background analysis of the forces operating in the market for corporate control -- analysis which provides an understanding of the conflicts and issues surrounding takeovers and the effects of activities in this market. Section 3 discusses the conflict between managers and shareholders over the payout of free cash flow and how takeovers represent both a symptom and a resolution of the conflict. Sections 4, 5, and 6 discuss the relatively new phenomena of, respectively, junk-bond financing, the use of golden parachutes, and the practice of greenmail. Section 7 analyzes the problems the Delaware court is having in dealing with the conflicts that arise over control issues and its confused application of the business judgment rule to these cases. The following topics are discussed: - The reasons for takeovers and mergers in the petroleum industry and why they increase efficiency and thereby promote the national interest. - The role of debt in bonding management's promises to pay out future cash flows, to reduce costs, and to reduce investments in low-return projects. - The role of high-yield debt (junk bonds) in helping to eliminate mere size as a takeover deterrent. - The effects of takeovers on the equity markets and claims that managers are pressured to behave myopically. - The effects of antitakeover measures such as poison pills. - The misunderstandings of the important role that golden parachutes play in reducing the conflicts of interests associated with takeovers and the valuable function they serve in alleviating some of the costs and uncertainty facing managers. - The damaging effects of the Delaware court decision in Unocal vs. Mesa that allowed Unocal to make a self-tender offer that excluded its largest shareholder (reverse greenmail). - The problems the courts are facing in applying the model of the corporation subsumed under the traditional business judgment rule to the conflicts of interest involved in corporate controversies.
Abstract: The efficient market hypothesis has been widely tested and, with few exceptions, found consistent with the data in a wide variety of markets: the New York and American Stock Exchanges, the Australian, English, and German stock markets, various commodity futures markets, the Over-the-Counter markets, the corporate and government bond markets, the option market, and the market for seats on the New York Stock Exchange. Yet, in a manner remarkably similar to that described by Thomas Kuhn in his book, The Structure of Scientific Revolutions, we seem to be entering a stage where widely scattered and as yet incohesive evidence is arising which seems to be inconsistent with the theory. As better data become available (e.g., daily stock price data) and as our econometric sophistication increases, we are beginning to find inconsistencies that our cruder data and techniques missed in the past. It is evidence which we will not be able to ignore. The purpose of this special issue of the Journal of Financial Economics is to bring together a number of these scattered pieces of anomalous evidence regarding Market Efficiency. As Ball (1978) points out in his survey article: taken individually many scattered pieces of evidence on the reaction of stock prices to earnings announcements which are inconsistent with the theory don't amount to much. Yet viewed as a whole, these pieces of evidence begin to stack up in a manner which make a much stronger case for the necessity to carefully review both our acceptance of the efficient market theory and our methodological procedures.
market efficiency, Efficient Market Theory, theory of 'random walks', rational expectations theory, abnormal returns, asset pricing model
Abstract: Presented at the Center for Public Leadership, John F. Kennedy School of Government, Harvard University, Boston, MA, May 10, 2007. We present a positive model of integrity that provides powerful access to increased performance for individuals, groups, organizations, and societies. Our model reveals the causal link between integrity as we distinguish and define it, and increased performance and value-creation for all entities. And our model provides access to that causal link. The philosophical discourse, and common usage as reflected in dictionary definitions, leave an overlap and confusion among the four phenomena of integrity, morality, ethics, and legality. This confounds the terms so that the efficacy and potential power of each of them is seriously diminished. In this new model, we distinguish all four phenomena integrity, morality, ethics, and legality as existing within two separate realms, and within those realms as belonging to distinct and separate domains. Integrity exists in a positive realm devoid of normative content. Morality, ethics and legality exist in a normative realm of virtues, but in separate and distinct domains. This new model: 1) encompasses all four terms in one consistent theory, 2) makes the moral compass potentially available in each of the three virtue phenomena clear and unambiguous, and 3) does this in a way that raises the likelihood of those now clear moral compasses actually shaping human behavior. This all falls out primarily from the unique treatment of integrity in our model as a purely positive phenomenon, independent of normative value judgments. Integrity is thus not about good or bad, or right or wrong, or what should or should not be. We distinguish integrity as a phenomenon of the objective state or condition of an object, system, person, group, or organizational entity, and define integrity as: a state or condition of being whole, complete, unbroken, unimpaired, sound, perfect condition. We assert that integrity (the condition of being whole and complete) is a necessary condition for workability, and that the resultant level of workability determines the available opportunity for performance. Hence, the way we treat integrity in our model provides an unambiguous and actionable access to superior performance (however one wishes to define performance). For an individual we distinguish integrity as a matter of that person's word being whole and complete, and for a group or organizational entity as what is said by or on behalf of the group or organization being whole and complete. In that context, we define integrity for an individual, group, or organization as: Honoring one's word. Oversimplifying somewhat, honoring your word as we define it means you either keep your word (do what you said you would do and by the time you said you would do it), or as soon as you know that you will not, you say that you will not to those who were counting on your word and clean up any mess caused by not keeping your word. Honoring your word is also the route to creating whole and complete social and working relationships. In addition, it provides an actionable pathway to earning the trust of others. We demonstrate that the application of cost-benefit analysis to one's integrity guarantees you will not be a trustworthy person (thereby reducing the workability of relationships), and with the exception of some minor qualifications ensures also that you will not be a person of integrity (thereby reducing the workability of your life). Therefore your performance will suffer. The virtually automatic application of cost-benefit analysis to honoring one's word (an inherent tendency in most of us) lies at the heart of much out-of-integrity and untrustworthy behavior in modern life. In conclusion, we show that defining integrity as honoring one's word provides 1) an unambiguous and actionable access to superior performance and competitive advantage at both the individual and organizational level, and 2) empowers the three virtue phenomena.
Moral, Ethical, Legal, Performance, Quality of Life, Sincerity
Abstract: From the 1960s to the 1980s the corporate control market generated considerable controversy, first with the merger and acquisition movement of the 1960s, then with the hostile tender offers of the 1970s and most recently, with the leveraged buyouts and leveraged restructurings of the 1980s. These control transactions are the manifestation of powerful underlying economic forces that, on the whole, are productive for the economy. Thorough understanding is made difficult by the fact that change, as always, is threatening - and in this case the threats disturb many powerful interests. One popular hypothesis offered for the current activity is that Wall Street is engineering transactions to buy and sell fine old firms out of pure greed. The notion is that these transactions reduce productivity, but generate high fees for investment bankers and lawyers. The facts do not support this hypothesis even though mergers and acquisitions professionals undoubtedly prefer more deals to less, and thus sometimes encourage deals (like diversifying acquisitions) that are not productive. There has been much study of corporate control activity, and although the results are not uniform, the evidence indicates control transactions generate value for shareholders. The evidence also suggests that this value comes from real increases in productivity rather than from simple wealth transfers to shareholders from other parties such as creditors, labor, government, customers or suppliers. My purpose here is to outline an explanation of the fundamental underlying cause of this activity that has to date received no attention. In this paper I define active investors, explain their fundamentally important role in generating corporate efficiency, show how current corporate control activity is part of a larger set of economic changes sweeping the world, provide perspective on how LBOs, restructurings, and increased leverage in the corporate sector fit into the overall picture, and discuss some reasons why high debt ratios and insolvency are less costly now than in the past. Because of its topical relevance, I pay particular attention to LBOs and their role in the restoration of competitiveness in the American corporation.
Active Investors, Investors, Mergers and Acquisitions, Control Transactions, Corporate Control Activity, Takeover Activity, Corporate Efficiency, LBOs, Restructurings
Abstract: In this paper I derive a risk-adjusted measure of portfolio performance (now known as Jensen's Alpha) that estimates how much a manager's forecasting ability contributes to the fund's returns. The measure is based on the theory of the pricing of capital assets by Sharpe (1964), Lintner (1965a) and Treynor (Undated). I apply the measure to estimate the predictive ability of 115 mutual fund managers in the period 1945-1964 - that is their ability to earn returns which are higher than those we would expect given the level of risk of each of the portfolios. The foundations of the model and the properties of the performance measure suggested here are discussed in Section II. The evidence on mutual fund performance indicates not only that these 115 mutual funds were on average not able to predict security prices well enough to outperform a buy-the-market-and-hold policy, but also that there is very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance. It is also important to note that these conclusions hold even when we measure the fund returns gross of management expenses (that is assume their bookkeeping, research, and other expenses except brokerage commissions were obtained free). Thus on average the funds apparently were not quite successful enough in their trading activities to recoup even their brokerage expenses.
Jensen's Alpha, mutual fund performance, risk-adjusted returns, forecasting ability, predictive ability
Abstract: In this paper I explore the effects of politics on corporate finance, including the determinants of capital structure and the regulatory and legal factors governing the market for corporate control. I examine the effects and consequences of the active corporate control market of the 1980s, then I outline the enormous political controversy and inaccurate media portrayals that ensued, and contrast them to the results obtained from intensive study of the phenomena by academic economists. First, I review new macroeconomic evidence on changes in productivity in American manufacturing that is dramatically inconsistent with popular claims that corporate control transactions were crippling the industrial economy in the 80s. Second, I show how the restructuring movement of the 1980s reflected the re-emergence of active investors in the U.S. and how restructuring addressed the conflict between management and shareholders over control of corporate free cash flow. Third, I summarize my conception of LBO associations as new organizational forms that overcome the deficiencies of large public conglomerates. I also discuss the similarity between LBO associations and Japanese business financing networks known as keiretsu. Fourth, I argue that the highly-leveraged financial structures of the 1980s should lead to a Japanese-style privatization of bankruptcy (i.e., out-of-court reorganization). Fifth, I present a theory of boom-bust cycles in venture markets that explains why many companies involved with late-1980s leveraged transactions encountered financial distress. Sixth, I argue that misguided changes in the tax and regulatory codes and in bankruptcy court decisions have distorted the normal economic incentives for out-of-court reorganizations, resulting in increased costs of financial distress and a sharp rise in the number of Chapter 11 filings. Seventh and last, I propose a set of changes in the Chapter 11 process designed to reduce the costs of financial distress and thus maximize the total value of the firm to all investors.
corporate control, corporate finance, highly leveraged transactions (HLTs), mergers, tender offers, divestitures, LBOs, KKR, contracting problems, agency costs, active investor, LBO Association, takeovers, privatization of bankruptcy, keiretsu, deregulation, re-regulation, Congress, government
Abstract: Economic analysis and evidence indicate that the market for corporate control is benefiting shareholders, society, and the corporate form of organization. The value of transactions in this market ran at a record rate of about $180 billion per year in 1985 and 1986, 47 percent above the 1984 record of $122 billion. The gains to shareholders from these transactions have been huge. The gains to selling firm shareholders from mergers and acquisition activity in the ten-year period 1977-86 total $346 billion (in 1986 dollars). The gains to buying firm shareholders are harder to estimate, and no one to my knowledge has done so as yet, but my guess is that they will add at least another $50 billion to the total. These gains, to put them in perspective, equal 51 percent of the total cash dividends (valued in 1986 dollars) paid to investors by the entire corporate sector in the past decade. These corporate control transactions and the restructurings that often accompany them are frequently wrenching events in the lives of those linked to the involved organizations: the managers, employees, suppliers, customers and residents of surrounding communities. Restructurings usually involve major organizational change (such as shifts in corporate strategy) to meet new competition or market conditions, increased use of debt, and a flurry of recontracting with managers, employees, suppliers and customers. This activity sometimes results in expansion of resources devoted to certain areas and at other times in contractions involving plant closings, layoffs of top-level and middle managers, staff and production workers, and reduced compensation. Those threatened by the changes that restructuring brings about argue that corporate restructuring is damaging the American economy, damaging the morale and productivity of organizations, and pressuring executives to manage for the short-term. Further, they hold that the value restructuring creates does not come from increased efficiency and productivity; instead, the gains come from lower tax payments, broken contracts with managers, employees and others, and mistakes in valuation by inefficient capital markets. Since the benefits are illusory and the costs are real, they argue, takeover activity should be restricted. The controversy has been accompanied by strong pressure on regulators and legislatures to enact restrictions that would curb activity in the market for corporate control. Dozens of congressional bills in the last several years have proposed new restrictions on takeovers, but none have passed as of this writing. The Business Roundtable, composed of the chief executive officers of the 200 largest corporations in the country, has pushed hard for restrictive legislation. Within the past several years the legislatures of New York, New Jersey, Maryland, Pennsylvania, Connecticut, Illinois, Kentucky, Michigan, Ohio, Indiana and Minnesota have passed antitakeover laws. The Federal Reserve Board implemented new restrictions in early 1987 on the use of debt in certain takeovers. In all the controversy over takeover activity, it is often forgotten that only 40 (an all-time record) out of the 3,300 takeover transactions in 1986 were hostile tender offers. There were 110 voluntary or negotiated tender offers (unopposed by management) and the remaining 3,100-plus deals were also voluntary transactions agreed to by management, although this simple classification is misleading since many of the voluntary transactions would not occur absent the threat of hostile takeover. A major reason for the current outcry is that in recent years mere size alone has disappeared as an effective takeover deterrent, and the managers of many of our largest and least efficient corporations now find their jobs threatened by disciplinary forces in the capital markets. The market for corporate control is creating large benefits for shareholders and for the economy as a whole by loosening control over vast amounts of resources and enabling them to move more quickly to their highest-valued use. This is a healthy market in operation, on both the takeover side and the divestiture side, and it is playing an important role in helping the American economy adjust to major changes in competition and regulation of the past decade.
takeovers, corporate control, corporate restructuring, congress, Business Roundtable, tender offers, capital market
Abstract: Note: SSRN is experimenting with enabling the distribution of different types of files: slides, spreadsheets, video, etc. We are interested in our users desires to distribute files that go beyond word processing text files. You can communicate with me on these issues via my email address below. We invite you to submit your own presentation slides.
Finance theory and practice are incomplete without an integrated theory of integrity. Following Erhard, Jensen and Zaffron (2007) I define integrity without reference to morals, values, religion, or ethics. Something is in integrity if it is whole, complete and sound. Integrity is closely related to workability because an entity or system that is out of integrity will not be whole, complete and sound. Workability is the bridge to value. The farther out of integrity the less well any given entity will work.
The positive proposition that increasing the integrity of a firm will contribute to increasing its value is no different in kind from the positive proposition that the net present value investment rule will lead to value creation. The theory thus implies that integrity is a necessary, but not sufficient condition for the maximization of long-term value. The theory is testable and refutable.
I illustrate the application of this concept in finance by considering several examples: 1. The implicitly held proposition that firm's managers owe fiduciary responsibility to current shareholders only (excluding current and future bondholders and future shareholders). This leads to the widely held recommendation/belief that the appropriate action for a firm whose equity is substantially overvalued is to sell new equity and pay out the proceeds to current shareholders or to acquire a less overvalued firm through an equity transaction. Both of these policies will create a system in which future shareholders find that they have been taken in the transaction. Policies that expropriate wealth from future shareholders or bondholders cannot contribute to the creation of long-term value. Interestingly, U.S. disclosure laws provide some obligations for managers to take into account the interests of future bond and stockholders.
2. I discuss the extensive empirical evidence on the puzzling low-integrity value-destroying equilibrium between managers and capital markets and argue that understanding how this equilibrium continues to exist is a major challenge for our profession.
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PDF file of Keynote slides for speech first presented on the occasion of the presentation of the LECG Lifetime Achievement Award in Recognition of his Contributions to the Field of Financial Economics to Michael C. Jensen at the meetings of the American Finance Association, Boston, MA, Jan. 6, 2006; also presented to the Centre for Corporate Governance, London Business School, London, UK, Jan. 19, 2006; the Center for Corporate Governance, LeBow College of Business, Drexel University, Philadelphia, PA, March 1, 2006; Journal of Corporate Finance Conference on Private Equity, LBOs, and Corporate Governance, Rensselaer Polytechnic Institute, Troy, NY, April 21, 2006; CFO Forum, U. of Washington Business School, Seattle, WA, May 17, 2006, JOIMs Fall 2006 Conference, Boston, MA, Sept. 2006, Zicklin Center for Corporate Integrity, Baruch College, NYC, Oct. 2006; State Street Global Markets 7th Annual Research retreat, Boston, MA March 1, 2007: Society of Quantitative Analysts (SQA) Society, Fuzzy Day Conference, NY, NY, June 18, 2007; Smith Breeden Associates¿ Investment Research Seminar, Pinehurst, NC, Oct. 4, 2007; Tuck School of Business, Corporate Governance Workshop for Large Institutional Investors, Oct. 8, 2007; Deutsche Asset Management, Global Quantitative Investor Strategies: The Art of Alpha and Beta, NY, NY, Oct. 17, 2007; Financial Management Association, Orlando, FL, Oct. 18, 2007; DeAM European Investor Conference -- Alternative Sources of Alpha: The Art of Alpha and Beta, Berlin, Germany, Nov. 7, 2007; U. of South Florida and Society of Financial Analysts Conference on The Relationship of Value to Governance, Tampa, FL, Feb. 1; London Business School Private Equity Institute Seminar, April 14, 2008; Mays Business School, Texas A&M U. Feb. 10, 2009; and Keynote Address, Financial Intermediation Research Society (FIRS), Prague, Czech Republic, May 29, 2009.
Integrity, Lies, Lying, Managing Earnings, Smoothing Earnings, Collusion, Development, Disclosure Strategy, Fiduciary Responsibility, Financial Reporting, Accounting Errors, Fraud
Abstract: This paper is a review of the foundations and current state of mean-variance capital market theory. This work, whose foundations lie in the mean-variance portfolio model of Markowitz, deals with the determination of the prices of capital assets under conditions of uncertainty. The Sharpe-Lintner capital asset pricing model which forms the core of this body of literature is an investigation of the implications of the normative Markowitz model for the equilibrium structure of asset prices. The essential characteristics of these models are reviewed along with the current state of the empirical evidence bearing on them. Many of the recent extensions of the theory are also reviewed and some attempt is made to integrate these extensions with the currently available empirical evidence.
mean-variance capital asset pricing model, capital market theory, equilibrium, systematic risk, riskless borrowing, riskless lending, market efficiency
Abstract: Slide deck and course materials for Erasmus Academie Leadership Course June 8-12, 2009.
The following paragraph describes this course for someone who has no knowledge of what this material is about.
This Leadership course is different from others you may know of or have experienced. This course is based on the proposition that within everyone there is a natural latent leadership ability. Rather than teaching you "leadership strategies" or being a "how to guide", this course will help you identify and remove obstacles that keep you from accessing your innate leadership talent. Some obstacles to great leadership are inherent in and shared by all people-- a consequence of the way our brains work. And some obstacles are specific to each individual-- the result of individual history and experience. This course works to make you aware of these obstacles, and allows you to remove them and access your natural capacity for leadership
History and More on the Course
This presentation is based on our (and our co-instructors’) work over the last six years in developing a course of the same title at the University of Rochester Simon School of Business (which course is now also taught at the US Air Force Academy, was recently delivered at the Erasmus Academie (Rotterdam), a version of which is taught at the Erasmus University Law School, and will be taught at Texas A&M University). The course is still under development and will be for several more years. The course is designed to leave the participants being leaders and exercising leadership effectively as their natural self expression,
The course is not designed to merely leave the participants with knowledge (that is not designed to leave students “knowing” about leaders and leadership and able to discuss the issues surrounding leader and leadership). Rather the course is designed to give students actual access to being a leader and the effective exercise of leadership. Our promise as instructors to the students is that if they honor their word to fulfill the requests we make of them they will leave the course being leaders and exercising leadership effectively.
The research project that led to the creation of this course (and the papers and slides on leadership that are in the attached pdf file) originated from our interest in laying the foundations for a science of leadership. We agree with Warren Bennis (2002, p. 2) and Joseph Rost (1993, p. 8) who conclude respectively: "It is almost a cliche of the leadership literature that a single definition of leadership is lacking." and "The scholars do not know what it is they are studying, and the practitioners do not know what it is they are practicing."
Attacking the question of what leadership is required us to get into what it is to be a leader and what it is to exercise leadership effectively. Getting to the core of being a leader led naturally to attacking the task of creating leaders and the natural laboratory for exploring that question was the classroom. Mark Zupan, Dean of the U. of Rochester Simon School of Business provided us the laboratory to do this and the course was created.
We resolve the puzzle over what leadership is by uniquely distinguishing leader and leadership as the intersection of four precise aspects which are respectively: Leader and Leadership as 1. Linguistic Abstractions (leader and leadership as “realms of possibility”), 2. Phenomena (leader and leadership as experienced, that is, as exercised, or what one observes or is impacted by), 3. Concepts (the temporal domains in which leader and leadership function), 4. Terms (leader and leadership as definitions)
The access provided to (and therefore what is revealed about) leader and leadership when dealt with as a realm of possibility is different than the access provided to (and therefore what is revealed about) leader or leadership when they are dealt with as a phenomenon, or as a concept, or as a term.
We argue that when the four perspectives are taken together, as a whole they provide access to mastering what leader and leadership actually are. This enables us to get our arms around the being of a leader and the effective exercise of leadership. Having mastered this overall context, we can then get our hands on the levers and dials of being a leader, and the effective exercise of leadership.
What follows - in a single pdf document of 478 pages of PowerPoint slides, Word documents, and exhibits (roughly equivalent to a 200 page book) - is a collection of virtually all the materials used in the course.
Our desire is to make the course available to anyone to teach it, to communicate it and to extend it. This second pass release of the material is not fully complete nor is it polished to our standards. We will continue to update and extend the material and will revise these files. We are releasing the material so that we can benefit from the comments, criticisms and suggestions of others who share our desire to accelerate the development of a true science of leadership. We want to see this material (or material derived from it) taught in every major business school and university.
While the course is still a work in progress, we, the authors and instructors, are making all the materials available through SSRN (Social Science Research Network) to anyone who wishes to teach versions of the course in any university or college setting.
For the full introductory paper to the course: “The Ontological Constraints Limiting Access to Leadership: What You Must Take Away to Create Access to Being a Leader and the Effective Exercise of Leadership” see: http://ssrn.com/abstract=1238158
Abstract: This paper is the (pre-course) introduction document to an experimental leadership course developed by the authors and taught at the U. of Rochester Simon School of Business and the US Air Force Academy, and will be taught in June 2009 at the Erasmus Academie in Rotterdam. The title of the course is: "Being A Leader and The Effective Exercise Of Leadership: An Ontological Model". The intention of the course is to leave the participants actually being leaders and exercising leadership effectively, and for the course to contribute to creating a new science of leadership. The course is founded on what we term an ontological model of human nature.
More on the Course
By ontological we mean the following: If you have ever wondered what it would be like to be a bird, or wondered what it is like to be your dog, or to be a person of the opposite gender, or what it is like to be some particular friend of yours, you were in an ontological inquiry. You would also be in an ontological inquiry if you asked: What is it like to be a human being, or what is it like to be a leader?
Ontology as a general subject is concerned with the being of anything. However, here we are concerned with the ontology of human beings, and specifically with the ontology of leader and leadership. That is, we are concerned with the nature and function of being for human beings, and specifically with the nature and function of being a leader and the effective exercise of leadership.
For a narrower and therefore easier example of being, we can talk about being angry, or being antisocial, or being a person of character. We could examine these ways of being from the comfort of our somewhat familiar perspectives on human beings from the science of psychology, neuroscience, or genetics.
While less familiar for us and therefore perhaps at first uncomfortable, it is also possible to examine any of these ways of being from an ontological perspective. Here we would be examining the being aspect of being angry, or being antisocial, or being a person of character. (Webster's Dictionary (1998) defines being as "fundamental or essential nature".) From this perspective we clearly see that when we are being angry, we are likely to act in anger. Likewise for being antisocial, or being a person of character. From the ontological perspective it is clear that being constrains and shapes behavior.
The ontological perspective is particularly powerful when dealing with the being of being a leader, and the effective exercise of leadership. Like acting in anger when we are being angry, or acting with ease if we are being at ease, or acting with confidence when we are being confident, if we master the being of being a leader, we are likely to act as a leader and exercise leadership effectively. And, this course is about being a leader, and acting effectively in exercising leadership as a natural consequence of being a leader.
An epistemological mastery of a subject leaves you knowing. An ontological mastery of a subject leaves you being. Once again, this course is about access to being a leader and the effective exercise of leadership.
Effective leadership does not come from mere knowledge about what leaders do, or trying to emulate the characteristics or styles of noteworthy leaders, or from trying to remember and follow the steps, tips or techniques from books on leadership, and certainly not from merely being in a leadership position, or position of authority. If you are not being a leader, and you try to act like a leader, you are likely to fail. That's called being inauthentic, and inauthenticity (pretending to be a leader) is deadly in the attempt to exercise leadership.
It is obvious that to be effective in dealing with a leadership challenge one must be able to accurately perceive that challenge, and then act effectively in dealing with the challenge. However, neuroscience tells us that at least 80% of what we perceive is what our brain sees (comes from our memory), not what our eyes see. And, the 80% of our perception that comes from our memory is constrained and shaped by our network of ideas, beliefs, social and cultural embedded-ness, and taken-for-granted assumptions. Moreover, regardless of the accuracy of our perceptions, when in our attempt to deal with a leadership challenge there is a perceived threat to our identity, our freedom to act is high jacked by stimulus-response behavior, or what is often called a knee-jerk reaction. We term this limiting and shaping imposed on our perceptions and actions, Ontological Constraints.
The ontological approach to being a leader and the effective exercise of leadership opens up the possibility of eliminating many of these Ontological Constraints, including those most critical to being effective as a leader. Much of this course is devoted to providing participants with that opportunity.
The Underlying Theory of this Course: Part I
• Given that our way of being and our actions are a correlate of the way in which the circumstances we are dealing with occur (show up) for us, and • Given that the way the circumstances occur for us is limited and shaped by our Ontological Constraints, our being and actions when being a leader are not correlated with what is actually there, but rather with some distorted version of what is there, and • Given that these Ontological Constraints limit and shape our opportunity set for being and action, the most effective way of being and acting when being a leader is often unavailable to us. • Thus, gaining access to being a leader and the effective exercise of leadership requires that we loosen the grip of these debilitating Ontological Constraints, or to put it more simply, • We must take away what is for each of us individually in the way of our being a leader and exercising leadership effectively. • This accomplished, one only needs to distinguish being a leader and the effective exercise of leadership in a way that provides access to the natural expression of being a leader and the effective exercise of leadership.
The Underlying Theory of this Course: Part II
• We distinguish Leader and Leadership in a way that pierces through their complexity and clarifies their multidimensionality, and do so in a way that leaves participants with a natural access to being a leader and the effective exercise of leadership. • We produce this natural access by transforming participants’ Frame of Reference (mindset) for Leader and Leadership through the use of a unique contextual framework (structure for analysis) constituted by the following four distinct aspects of (or perspectives on) Leader and Leadership. • We distinguish Leader and Leadership as: o A Linguistic Abstraction o A Phenomenon o A Concept o A Term
Our Promise:
You will have experienced whatever personal transformation is required for you to leave the course being who you need to be to be a leader, and with what it takes to exercise leadership effectively. In other words, you will be a leader.
Leadership, Ontology, worldview, frames of reference, ontological constraints, functional constraints, perceptual constraints
Abstract: Note: SSRN is experimenting with enabling the distribution of different types of files: slides, spreadsheets, video, etc. This is the first upload of a pdf file of Powerpoint slides. We are interested in our users desires to distribute files that go beyond word processing text files. You can communicate with me via my email address below. Performance management is critical to the functioning of all organizations. It is a poorly understood phenomenon characterized as much by what people know that is wrong as it is by what people know that is right. Moreover, it is an area in which almost everyone views themselves as experts while having little idea about what they do not know. I review my recent thinking on the almost universal counterproductive effects of the ways most organizations tie rewards and punishments to budgets and targets (what I call paying people to lie), the damaging effects of stretch budgets, the apparently beneficial effects of breakthrough thinking, the puzzle regarding when and why breakthrough thinking does and does not devolve into paying people to lie, and some new ideas on the basic source of performance that come from the philosophy of ontology.
Productivity, incentives, performance, ontology, Barbados Group,
Abstract: This essay reviews the development of modern capital market theory (i.e., general equilibrium models of the prices of capital assets under conditions of uncertainty) and the empirical evidence bearing on this theory. There are two main approaches to this problem; the mean-variance models following in the Markowitz (1952; 1959) tradition, and the state preference models due originally to Arrow (1953) and Debreu (1959). Both approaches are generalizations to a world of uncertainty of the work of Irving Fisher (1965) on the theory of interest. The state preference approach- is more general than the mean-variance approach and provides a truly elegant framework for investigating theoretical issues, but unfortunately it has proved to be difficult to give it substantial empirical content. I shall restrict my attention here to the mean-variance models. Section II provides a brief review of the historical foundations of capital market theory and a statement of the assumptions and implications of the Sharpe-Lintner mean-variance model of asset pricing. Section III reviews our empirical knowledge about the process determining the structure of asset prices and returns. Section IV surveys recent theoretical developments in this area and integrates (to some extent) those developments with our empirical knowledge. Section V contains the conclusions.
mean-variance capital asset pricing model, capital market theory, equilibrium, systematic risk, riskless borrowing, riskless lending, market efficiency.
Abstract: Shareholders, who are the most important constituency of the modern corporation because they bear its residual risk, benefit most directly from acquisitions because of the increase in the value of target company shares. Many current criticisms directed at takeover activity are wrong or based on faulty logic. Takeovers protect shareholders from mismanagement of a corporation as they allow alternative management teams to compete for the right to manage the corporation's assets. The takeover market provides a unique, powerful, and impersonal mechanism to accomplish the major restructuring and redeployment of assets continually required by changes in technology and consumer preferences.
corporate takeovers-criticism, raiders, effect of takeovers on shareholders, golden parachutes, residual risk, manager-shareholder conflicts, mergers, importance of shareholders
Abstract: Keynote Address to the European Financial Management Association, London, June 2002 This paper received the European Financial Management Readers' Choice Best Paper Award for 2004 My intention today is to provide a way to understand some of what's currently happening in the world of finance and corporate governance at this time (June 2002). Few if any of us have discussed with our students the consequences of a company's stockprice becoming overvalued. Indeed I know of nowhere in the finance literature where the problems associated with overvaluation are discussed. We talked for a long time in the 1980s about the effects of under-valuation, and I will have a little to say about that below. But as things have progressed over the last half-dozen years overvaluation has come increasingly to occupy my thoughts. Indeed, understanding the incentive and organisational effects of stock overvaluation will help us understand much about the current malaise in corporate finance and corporate governance that surrounds the events at Enron, WorldCom, Xerox, and many other companies. I will review this situation briefly, and then move on to consider the agency costs of undervalued and overvalued equity. For the most part I'm going to concentrate on the latter, and examine the necessity for managers to manage stockprices down in situations where they become substantially overvalued, and the requirement for us to have new language to enable managers and boards to deal with these issues. I will conclude by considering how we solve this, where we go from here, and what's likely to happen?
Overvalued equity, Agency costs, budgeting, managing earnings, integrity, lying, scandals
Abstract: In this paper we provide a new definition of leadership that gives organizations and individuals access to new power, performance and accomplishment. In our model leadership consists of four critical elements: The creation of a vision for the future that represents a significant departure from the past, one that requires breakthroughs for its realization. The creation of a system that facilitates enrollment into and elicits voluntary commitment to the vision by the critical mass of people required to discover and implement the breakthroughs required for realization of the vision. The creation of a system that ensures both the timely identification of breakdowns (and the dissemination of information about them) that, if unresolved, would prevent the successful realization of the vision. The creation of a system for managing breakdowns that causes people to voluntarily recommit to the vision and maintain these commitments through to the implementation of the breakthroughs required for the realization of the vision.
Leadership, Breakthrough, Breakdown, Vision, Committed Speaking, Integrity
Abstract: Note: SSRN is experimenting with enabling the distribution of different types of files: slides, spreadsheets, video, etc. This is the second upload of a pdf file of Powerpoint slides. We are interested in our users desires to distribute files that go beyond word processing text files. You can communicate with me on these issues via my email address below. Top management teams and boards of directors stand between (and are under pressure from) both the capital markets and the internal managerial organization. These two groups speak different languages, and each perceives the firm and its purposes in different ways and evaluates performance according to their specific worldview. It is the job of top management and boards to manage the tensions between these two cultures. And few have been doing a good job of it. Neither culture is universally right. The capital market's perspective held the upper hand in the last bubble. And the result was much value destruction. It is time for firms to break this cycle of dependence to put balance back into the relations between internal management and external market forces, and put a halt to managing earnings (which is just another term for lying to the markets). I discuss the critical importance of Strategic Value Accountability (SVA) the missing concept in corporate governance, how the widespread distribution of equity-based compensation coupled with the failure to clearly assign SVA decision rights can lead to the value-destroying over-democratizations of SVA rights to managers that have neither the specific knowledge or talent to exercise these rights. I also discuss the dysfunctional consequences of the almost universal practice of linking annual managerial bonuses to budget and other targets, how it destroys value and how it leads to the erosion of integrity throughout organizations.
Budget Target Based Bonuses, Lying, Integrity, SVA, Strategic Value Accountability
Abstract: In this article we review the implications of the Nader proposals for Taming the Giant Corporation and the related campaigns for economic and corporate democracy. These campaigns, if successful, would impose costs on one group for the benefit of others, reduce economic efficiency and wealth, and finally would reduce, not increase, freedom. Corporate democracy advocates would impose restrictions on the freedom of individuals to associate, contract, and produce through the corporate form. In doing so they often use the analogy with the political state to buttress their arguments without coming to grips with the essential difference between the government (whether local, state or federal) and a corporation: Only a governmental has the legal monopoly over the use of physical coercion and violence on individuals (including arrest and imprisonment) to compel compliance with the dictates of the state. No corporation no matter how large has the police powers. No corporation has the legal right to use violence to compel any individual to buy from it, sell to it, invest in it, or work for it. We offer a new definition of freedom. Maximal freedom exists in a society if: (1) the rights system passes on to individuals the full set of opportunities provided by nature, and (2) the state enforces its monopoly over violence, and (3) each person has exclusive rights in his or her body. In this system the state is required to use coercion and violence to enforce the rights which resolve the physical incompatibility problem, and to maintain the state's monopoly over the use of violence. In conclusion we call on the various public interest lawyers and organizations to use their resources to increase freedom and aggregate welfare. They can do this by focusing their resources on preventing the use of the police powers for private benefit, for wealth confiscation, and for political theft.
definition of freedom, economic democracy, corporate democracy, corporategovernance, role of government, contracting, federal chartering, violence, police powers, rights
Abstract: It is traditional in the theory of the firm to define the production opportunity set available to the firm in terms of its boundary the maximum attainable set of output quantities for various input quantities, given the state of technology and knowledge. This boundary is the production function of the firm. One of our purposes here is to point out the dependence of such production functions on the structure of property rights and contracting rights within which the firm exists. We redefine the production function in order to recognize the dependence of output on the structure of property and contracting rights. That expanded framework is then used to discuss a concrete set of problems surrounding the role of labor in the firm ranging from the labor-managed firm system (in which tradable capital value residual claims [common stock] are legally prohibited), and the codetermination and industrial democracy movements (in which management participation by labor is required by law), to cooperatives and professional partnerships (i.e., quasi-labor-managed firms which arise out of the voluntary contracting process), and the capitalist corporation.
Labor Managed Firm, Property Rights, Contract Rights and Production Functions, Rules of the Game, Nexus of Contracts, Codetermination, Industrial Democracy, Cooperatives and Professional Partnerships
Abstract: Controlling the political process that threatens the free enterprise market system is a major social problem. This problem will not be solved until we develop a viable positive theory of the political process. Such a political theory will not be complete until we also have a theory that explains why we get the results we do out of the mass media. This paper is a first step in the development of a formal analysis of the behavior of the press (a term I use as a shorthand reference to all the mass media, including not only newspapers but news magazines, magazines, radio, and television). I argue that the mass media is best understood as producers of entertainment, not information, and that the theories and facts that people absorb from the media are a by-product of their consumption of the entertainment value of the news. In addition, peoples? intolerance of ambiguity causes them to demand answers to questions; including those that are unanswerable. As a result the media is generally in the business of providing simple answers to complex problems whose answers are unknown, and it must do so in an entertaining way. Complex answers, even if correct are not acceptable to consumers of the media, and therefore are soldom provided. To explain the anti-market bias of the media I argue that we must understand the family environment in which people are raised. I outline a theory of the family that is based on the notion that all exchanges must be balanced if two or more parties are to continue in relationship. The family is characterized by the absence of quid pro quo exchanges, and I argue that this occurs because it is inefficient in such relationships to keep the books balanced on a transaction by transaction basis. As a result, the family is organized around non quid pro quo exchanges, and this causes people to erroneously believe that such exchanges are the appropriate way to organize large groups or even societies. This element of consumer demand helps explain why the press is generally biased in its presentation of market vs. collectivist solutions to problems faced in modern societies. I examine the rewards and penalties that the media and its sources can impose on each other to explain why and when the media will protect some sources of information and why they attack others. Finally I analyze the entrepreneurial aspects of journalism, including the media?s interest in helping to manufacture crises.
Abstract: One of the tactics politicians use in their quest for power is to draw a false distinction between human rights and property rights. Property rights are, in the last analysis, rights of individuals. As investors, who have a direct stake in the property rights of corporation, become less certain that society will honor those rights, the capitalized values of corporate securities will erode - ultimately to the point that many corporations will be able to remain in business only so long as they can finance their operations from internally generated cash flow or public subsidy.
Rights, regulation, private enterprise, contracts, rights, regulation, private enterprise, contracts
Abstract: This paper will review the empirical evidence on the market model and discuss its implications for security analysis. To begin this discussion, let me point out that the Market Model, or what Sharpe (1963) originally called the diagonal model, and the Capital Asset Pricing Model are very distinct models. Neither one depends in any way on the other. Many people confuse these two models but they refer to quite different concepts and it is well to keep the distinction clearly in mind. This paper will consider the major characteristics of the Market Model, provide some illustrative examples and briefly summarize the evidence. A Technical Paper prepared in connection with this paper considers the major characteristics of the Asset Pricing Model and a discussion of the theoretical and empirical content of the Two Factor Model.
market model, capital market theory, capital asset pricing model, market returns, two factor model, market returns, diversification, market forecasts, risk
Abstract: PDF file of slides for Keynote Speech at the RFS-IU Conference on The Causes and Consequences of Recent Financial Market Bubbles, Aug. 12-13, 2005, Bloomington, IN Note: SSRN is experimenting with enabling the distribution of different types of files: slides, spreadsheets, video, etc. This is the third upload of a pdf file of Powerpoint slides. We are interested in our users desires to distribute files that go beyond word processing text files. You can communicate with me on these issues via my email address below. I discuss the growing lack of integrity between managers and capital markets, some of the causes of this situation and its value destroying effects. I define what I mean by integrity (a system or entity which is whole, complete and stable), and the various levels of integrity, and discuss the implications that entities or systems that are out of integrity don't work. I discuss how it has become part of every top manager's job over recent decades to manage earnings and how it is that anytime a manager makes a decision to manage earnings that is other than what would be required to maximize firm value, he or she has lied. Some are upset by such strong language to describe this phenomenon. But when we refuse to label these lies for what they are we disable the normal social sanctions in management systems and boards of directors that would help limit such activities. I argue that finance scholars have contributed to this lack of integrity, for example, by failing to recognize that management and board fiduciary responsibility extends beyond current bondholders and stockholders to future bondholders and stockholders as well. I discuss a few of the studies that indicate both managers and analysts have engaged in less than truthful behavior. While each of the studies when viewed in isolation can be called into question on various grounds, when viewed as a whole they paint a picture that indicates something is not right in this market. It appears managers and analysts are involved in some sort of collusive equilibrium, but I cannot understand how that could be sustained in this market with so many players on both sides. This is the puzzle that requires more attention by researchers in finance and accounting.
Integrity, Lies, Lying, Managing Earnings, Smoothing Earnings, Collusion
Abstract: This paper discusses five common divisional performance measurement methods - cost centers, revenue centers, profit centers, investment centers, and expense centers - while providing a theory that explains when each of these methods is likely to be the most efficient. The central insight of the theory is that each method offers a different way of aligning decision-making authority with valuable 'specific knowledge' inside the organization.
The theory suggests that cost and revenue centers work best in cases where headquarters has good information about cost and demand functions, product quality, and optimal output mix. Profit centers - defined as business units whose managers have responsibility for overall profits, but not the authority to make major capital spending decisions - tend to supplant revenue and cost centers when line managers have a significant informational advantage over headquarters and when there are few interdependencies (or 'synergies') between divisions. Investment centers - profit centers in which unit managers are allowed to make major investment decisions - tend to prevail when the activity is capital-intensive and when it is difficult for headquarters to identify the value-maximizing investment strategy for the business unit.
In evaluating the performance of profit centers, rate-of-return measures like ROA are likely to be effective when unit managers do not have major influence over the level of new investment. But, in the case of investment centers, Economic Value Added, or EVA, is likely to be the most effective single-period measure because it is designed to encourage only value-increasing investment decisions.
Performance measurement, cost center, profit center, investment center, expense center, specific knowledge, general knowledge
Abstract: In evaluating the performance of profit centers, rate-of-return measures like ROA are likely to be effective when unit managers do not have major influence over the level of new investment. But, in the case of investment centers, Economic Value Added, or EVA, is likely to be the most effective single-period measure because it is designed to encourage only value-increasing investment decisions.The theory suggests that cost and revenue centers work best in cases where headquarters has good information about cost and demand functions, product quality, and optimal output mix. Profit centers - defined as business units whose managers have responsibility for overall profits, but not the authority to make major capital spending decisions - tend to supplant revenue and cost centers when line managers have a significant informational advantage over headquarters and when there are few interdependencies (or “synergies”) between divisions. Investment centers - profit centers in which unit managers are allowed to make major investment decisions - tend to prevail when the activity is capital-intensive and when it is difficult for headquarters to identify the value-maximizing investment strategy. This classic by the formulators of agency cost theory discusses five common divisional performance measurement methods - cost centers, revenue centers, profit centers, investment centers, and expense centers - while providing a theory that attempts to explain when each of these methods is likely to be the most efficient. The central insight of the theory is that each method offers a different way of aligning decision-making authority with valuable “specific knowledge” inside the organization. The theory suggests that cost and revenue centers work best in cases where headquarters has good information about cost and demand functions, product quality, and optimal output mix. Profit centers - defined as business units whose managers have responsibility for overall profits, but not the authority to make major capital spending decisions - tend to supplant revenue and cost centers when line managers have a significant informational advantage over headquarters and when there are few interdependencies (or “synergies”) between divisions. Investment centers—profit centers in which unit managers are allowed to make major investment decisions - tend to prevail when the activity is capital-intensive and when it is difficult for headquarters to identify the value-maximizing investment strategy. In evaluating the performance of profit centers, rate-of-return measures like ROA are likely to be effective when unit managers do not have major influence over the level of new investment. But, in the case of investment centers, Economic Value Added, or EVA, is likely to be the most effective single-period measure because it is designed to encourage only value-increasing investment decisions.
Abstract: This issue of the Journal of Financial Economics contains the first set of studies in the new Clinical Papers section. The objective of this section is to provide a high-quality professional outlet for scholarly studies of specific cases, events, practices, and specialized applications. By supplying insights about the world, challenging accepted theory, and using unique sources of data, clinical studies stand on their own as an important medium of research. Like the medical literature from which the term 'clinical' is borrowed, these articles will frequently deal with individual situations or small numbers of cases of special interest. The JFE intends to take a leading role in encouraging clinical studies, guided by the confidence that expanding our research agenda and providing an outlet for this work will enliven and enrich professional knowledge. We expect these clinical studies to stimulate new high-quality empirical and theoretical research, Innovation in financing techniques, deregulation, reregulation, and changes in the organization and conduct of commerce are proceeding at a rapid rate. New products and practices are appearing constantly, and the roles and activities of financial institutions are changing dramatically. New ways to communicate these interesting changes to the scientific community are required because the changes provide tests of leading theories and suggest new problems of theoretical interest. Clinical papers, inspired primarily by actual events, can play an important role in this discovery and communication process and, therefore, in the evolution of the science of finance. The advantages of specialization imply that different groups of researchers will tend to concentrate on theory, empirical tests, and clinical studies. These three groups complement each other. Theory provides logical discipline and precise hypotheses for both empirical and clinical research. Empirical tests direct theorists by identifying irrelevant models and suggest where clinical research might find counterexamples. Clinical studies help set the agenda for both theory and empirical work. Because of this complementarity and the importance of communication between these groups, the Journal of Financial Economics is committed to publishing all three types of research.
Clinical Papers, case studies, perfect and imperfect markets
Abstract: I have two separate but related topics to cover today. The first is a critical appraisal of the state of accounting research, and the second is an analysis of current trends in the regulation of accounting practices and where they are leading us. Research in accounting has been (with one or two notable exceptions) unscientific. Why? Because the focus of this research has been overwhelmingly normative and definitional. As a result, the field has produced remarkably little theory or evidence bearing on positive issues. I am not claiming that accounting lacks theories. Quite the contrary; accountants promulgate theories (Edwards and Bell [1961], Sprouse and Moonitz [1962], Chambers [1966], ASOBAT [1966], Ijiri [1967], Sterling [1970]), as rapidly as the SEC increases disclosure requirements. But in accounting the term theory has come to mean normative proposition. I do not intend my emphasis here on positive analysis to imply that normative issues regarding what should be are unimportant. Neither academics nor professionals, however, will make significant progress in obtaining answers to the normative questions they continue to ask until they make a more serious attempt to develop a body of positive theory. It is in this sense that I believe much of what is classified as accounting research is useless. The dearth of positive theory explains the almost complete lack of impact of normative accounting research on professional practice. Furthermore, the belief held by many professionals that the new Professional Schools of Accounting will somehow improve accounting research, itself implies a disappointment with the payoffs from past accounting research. This failure has not been quite as dramatic in the managerial accounting area where issues such as capital budgeting and transfer pricing have received considerable attention.
Abstract: This paper enlarges upon some recent work regarding the appropriate discount rate for public projects and, in particular, shows more fully why risk should enter into the calculation. Indeed, we argue that efficient allocation of risk bearing is usually more difficult for government projects than it is for private ones. Therefore, if anything, the allowance for risk should be greater for government projects than it is for other-wise comparable private ones (assuming no distortions from competitive equilibrium). We then outline the implications of recent mean-variance asset pricing models for the project evaluation framework, providing an integration of the treat-ment of risk with Harberger's (1968) solution to the distortion problem. In the context of this theory we also offer specific arguments on the risks of different types mid classes of govern-ment projects.
risk, risk bearing, mean-variance asset pricing model, public investment, discount rate, riskless investment, diversification, distortion
Abstract: The market far corporate control that has arisen in the last two decades is generating large benefits for shareholders and for the economy as a whole. The corporate control market generates these gains by loosening control over vast amounts of resources and making it possible for those resources to move more quickly to their highest-valued use. This occurs through: takeovers, both hostile and friendly; divestitures; spinoffs; liquidations; leveraged buyouts; and going private transactions. We are seeing a normal healthy market in operation, both on the takeover side and on the divestiture side. The total benefits have been huge as reflected in gains of 535 billion to stockholders of acquiring and acquired firms in approximately the 50 largest takeovers in the last four years. Since takeovers are investments taken under great uncertainty, it is not surprising that, as in every investment activity, not all ventures are successful. Those who criticize takeovers and mergers by pointing to those that fail are missing the point. On average, takeovers create value through increased efficiencies of various types.
Takeovers, mergers, raiders, corporate control, value creation, restructuring, spinoffs, leveraged buyouts, going private transactions
Abstract: Abstract not available at this time.
Abstract: The corporation as an organizational form is an enormously productive social invention. Partly because of its success it is under increasing attack from various quarters, often under the guise of protecting investors from self-interested managers. Some of these attacks are successful simply because the corporation is a poorly understood entity. This paper discusses what the corporation is, what it is not, and how certain misconceptions about the corporate form are fostered by its critics as part of their attack.
Social responsibility, survival, definition of corporation, corporate democracy, federal chartering, Corporate Democracy Act, corporate control, government involvement
Abstract: In this report, the tax effects of leveraged buyouts (LBOs) based on the current tax law and data from LBOs during the period 1979 through 1985 are examined. The analysis challenges the argument that LBOs result in net losses of tax revenues to the U.S. Treasury. Five ways are shown in which LBOs can generate incremental revenues to the U.S. Treasury: increased capital gains taxes for shareholders; increased operating revenues; interest income earned by LBO creditors; more efficient use of capital; and asset sales triggering additional corporate taxes on the capital gains. Offsetting these incremental revenue gains are: increased interest deductions on the LBO debt and lower tax revenues on dividends foregone. We conclude that the U.S. Treasury's revenues from LBO firms have increased over the time period examined and that policies that restrict LBOs likely will reduce future tax revenues received by the Federal government.
Abstract: The papers in this volume and briefly summarized in this introduction document that: (1) executive compensation is positively related to share price performance: (2) poor firm performance is associated with increased executive turnover; (3) managers choose accounting accruals in ways, that increase the value of their bonus awards; (4) the adoption of new short- and long-term executive compensation plans and golden parachutes are associated with positive share price reactions; (5) the death of a firm's founder is associated with positive share price reactions; and (b) managers are less likely to make merger bids that lower their stock prices when they hold more stock in their firm. These findings are interpreted as generally supporting the view that executive compensation packages help align managers' and shareholders' interests.
executive compensation, performance, golden parachutes, share price reaction, manager and shareholder interest
Abstract: The purpose of this paper is to examine the problem faced by the portfolio manager attempting to optimally incorporate forecasts of future market returns into his portfolio. Given the solution to this problem we then shall focus our attention on the problem involved in measuring a portfolio manager's ability when he is explicitly engaged in forecasting the prices on individual securities (i.e., security analysis) and in forecasting the future course of market prices (i.e., timing activities). We shall consider these problems here in the context of the Sharpe-Lintner mean-variance general equilibrium model of the pricing of capital assets, and in the context of the expanded two factor version of the Sharpe model suggested by Black, Jensen and Scholes (1972) In addition we shall concentrate our attention here on an investigation of just what can and cannot be said about portfolio performance solely on the basis of data on the time series of portfolio and market returns. In section 2 we outline the foundations of the analysis and its relationship to the general equilibrium structure of security prices given by the Sharpe-Lintner model. In section 3 we briefly summarize the measure of security selection ability suggested by Jensen (1968). Section 4 contains a solution to the problem of the optimal incorporation of market forecasts into portfolio policy and provides the structure for the analysis in section 5 of the measurement problems introduced into the evaluation of portfolio performance by market forecasting activities by the portfolio manager. Section 6 presents the complete development of the model within the two factor equilibrium model of the pricing of capital assets suggested by Black (1970) and Black, Jensen and Scholes (1972). Section 7 contains a brief summary of the conclusions of the analysis.
Abstract: We develop a framework that is applicable to all freedom of expression disputes. Our framework is based on the meaning of freedom which is based on the meaning of scarcity, and which, in turn, is based on the existence of physical incompatibilities. To maximize freedom, one must differentiate between scarce and non-scarce rights. Scarce rights can not be granted to everyone because of natural limitations caused by physical incompatibilities. If one person burns a tree for warmth, another cannot use the tree to build a house. Conflicts caused by such physical incompatibilities are resolved peacefully by giving exclusionary rights in the physical use of the tree to a single, private party. These are scarce rights because more than one person cannot use the tree when there are physical incompatibilities. Non-scarce rights, in contrast, can be granted to everyone. The contents of one's speech, for example, in no way limits what other people can may say or do. To maximize freedom, each scarce right must be assigned to some individual person, and all non-scarce rights should be assigned to everyone. We use this framework to provide an integrated and consistent analysis of prominent Supreme Court rulings on free speech issues, including public access to government and private property, symbolic speech (including flag burning), libel, and obscenity.
Freedom, First Amendment, property rights, externality, physical incompatibility, scarce rights, non-scarce rights, constitutional law
Abstract: I have long supported increased managerial holdings of equity to reduce the conflicts of interest between stockholders and their agent managers. Yet I recommend that a company never again issue another typical standard executive stock option. The vast increase in the use of options in managerial compensation plans in the last decade does not suffice to identify managers' interests with those of their stockholders and with that of society. My purpose here is to call attention to the fact that typical executive stock options are not structured properly and as a result reward managers for taking actions that destroy value. I also outline how the cost of capital adjusted options first suggested by Stewart (1990) can resolve these problems and recommend that newly awarded executive stock options be structured this way.
Performance Measurement, compensation, rewards, value destruction
Abstract: The paper by Morck, Shleifer, and Vishny contributes significantly to our knowledge of the takeover process. The authors conclude that the motive for friendly acquisitions is more likely to be synergistic, whereas in hostile ones it is more likely to be disciplinary. Hostile targets were older, slow growing firms that were investing a smaller fraction of earnings than the average firm in the sample and whose capital was valued by the market at less than half its replacement cost-all of which is consistent with the theory of the agency costs of free cash, which predicts that managers will generally disinvest too slowly. I agree with the authors' conclusions, but there are a number of things the authors did not examine that would have considerably improved our understanding of the issues. The authors did not consider takeover attempts that were unsuccessful, that is, attempts in which the target firm remained independent. Their conclusions apply only to friendly or hostile acquisition targets that were eventually taken over. The authors therefore missed an opportunity to tell us something about firms that were more likely to fail at a friendly deal or more likely to successfully fight off a hostile offer.
takeovers, hostile acquisitions, takeover process, hostile vs. friendly targets, value, agency costs
Abstract: The right to bring an action in court is an important right which many argue should be granted liberally. The United States Supreme Court, for example, has held that under certain situations access to court is a citizen's fundamental right. This paper discusses one facet of access to the courts, namely, standing to sue: the legal doctrine shaped by both courts and legislatures which determines who can bring a particular lawsuit. Discussions of standing have tended to focus on normative arguments about what standing should be while often neglecting positive implications of alternative standing doctrines. Standing doctrines that either increase or decrease access to court have predictable consequences relevant to the Supreme Court's admonition that standing decisions should be predicated not only upon constitutional considerations but also on practicalities and prudential consequences. Our analysis shows that many liberalizations of standing block the transfer of resources from less valuable to more valuable uses. In that regard they are, to use the Supreme Court's language, impractical and imprudent. In economic terms, standing that is too liberal generates inefficiencies. Section I explores the different consequences of polar standing rules: A rule that allows only one person standing in a particular suit is contrasted with a rule that allows everyone standing. Here, as in most of the paper, the analysis focuses on private lawsuits and ignores lawsuits brought against public officials. Section II summarizes the relevant literature and reviews the liberalizations of standing over the past twenty years. Section III discusses the largely unrecognized relationship between restrictive standing, alienable rights, and efficiency; also reviewed here are class action lawsuits and standing to sue public officials. Section IV contains the conclusions.
standing, legal doctrine, U.S. Supreme Court, rights, efficiency, transaction costs, alienability
Abstract: A considerable amount of statistical investigation of security price movements by economists and statisticians indicates that successive changes in security prices are (for all practical purposes) independent random variables. That is, all the statistical evidence indicates that future security price changes cannot be predicted by using the past price series. This has become known as the theory of random walks. It implies that the trading rules and security selection procedures long advocated by "technical" analysts or "chartists", which are based solely on past price movements, will not be useful in aiding the investor to increase his returns. The technical analysts have responded to the evidence presented by the academicians by claiming their models and theories are not really captured by these statistical tests. Alexander (1961; 1964) and Fama and Blume (1966) have examined the returns earned by various "filter" rules for selecting securities which purportedly capture the essence of many technical theories. The evidence indicates these trading rules are not able to consistently earn returns superior to those of a simple buy and hold policy. Thus, the results of these studies also support the random walk hypothesis. Robert Levy (1966; 1967) has recently tested a number of additional trading rules based on technical theories. Some of his results seem to be inconsistent with the theory of random walks. In particular Levy's article, "Random Walks: Reality or Myth" (1967) contains interesting results regarding the returns earned by several mechanical stock market trading rules in the five-year period October 1960 to October 1965. Levy calculates the returns earned by a number of variations of his trading rules and finds these returns generally higher than the returns earned on a "random selection policy." Commenting on these results Levy states: "The evidence above conclusively proves that technical stock analysis could have produced greater-than-random profitability at less-than-random risk for the 1960-1965 period." On this basis he concludes that "...the theory of random walks has been refuted." Unfortunately, his results do not completely support these strongly worded statements. His results have not refuted the random walk hypothesis and indeed they are subject to criticism on a number of points. It is the purpose of this "Comment" to point out and clarify some of the issues not adequately treated by Levy.
Abstract: Is there a fundamental conflict between a political democracy as we know it and a free market, private enterprise or capitalist system ? William Meckling and Michael Jensen of the University of Rochester, New York, believe that indeed there is, and that it is only a matter of time before the political sector eliminates most of the freedoms we still enjoy in the private sector of the economy. The first part of this study, contributed by Michael Jensen, describes the gradual destruction of individuals" rights and the attack on business corporations; the second part, by William Meckling, discusses why freedom is being destroyed, how the press helps governments to destroy it, and what can be done to stop it.
rights, freedom, free market, private enterprise, political democracy, human rights, property rights, co-determination laws
Abstract: The main purpose of this study is the development of a model for evaluating the performance of portfolios of risky assets taking into account the effects of differential risk on required returns. The portfolio evaluation model developed here incorporates these risk aspects explicitly by utilizing and extending recent theoretical results by Sharpe (1964) and Lintner (1965) on the pricing of capital assets under uncertainty. Given these results, a measure of portfolio performance (which measures only a manager's ability to forecast security prices) is defined as the difference between the actual returns on a portfolio in any particular holding period and the expected returns on that portfolio conditional on the riskless rate, its level of systematic risk, and the actual returns on the market portfolio. Criteria for judging a portfolio's performance to be neutral, superior, or inferior are established. A measure of a portfolio's efficiency is also derived, and the criteria for judging a portfolio to be efficient, superefficient, or inefficient are defined. I also show that it is strictly impossible to define a measure of efficiency solely in terms of ex post observable variables. I define two forms of the efficient market hypothesis, the weak form and the strong form (following terminology introduced by Harry Roberts, who used these terms in an unpublished speech entitled Clinical vs. Statistical Forecasts of Security Prices, given at the Seminar on the Analysis of Security Prices sponsored by the Center for Research in Security Prices at the Univ. of Chicago, May 1967. One can define a weakly efficient market in the following sense: Consider the arrival in the market of a new piece of information concerning the value of a security. A weakly efficient market is a market in which it may take time to evaluate this information with regard to its implications for the value of the security. Once this evaluation is complete, however, the price of the security immediately adjusts (in an unbiased fashion) to the new value implied by the information. In such a weakly efficient market, the past price series of a security will contain no information not already impounded in the current price. In such a market, forecasting techniques which use only the sequence of past prices to forecast future prices are doomed to failure. The best forecast of future price is merely the present price plus the normal expected return over the period. The available evidence suggests that it is highly unlikely that an investor or portfolio manager will be able to use the past history of stock prices alone (and hence mechanical trading rules based on these prices) to increase his profits. However, the conclusion that stock prices follow the weak form of the efficient market hypothesis allows for an investor to increase his profits by improving his ability to predict and evaluate the consequences of future events affecting stock prices. This brings us to the strong form definition of an efficient market, that is, one in which all past information available up to time t is impounded in the current price. If security prices conform to the strong form of the hypothesis, no analyst will be able to earn above-average returns by attempting to predict future prices on the basis of past information. The only individual able to earn superior returns will be that person who occasionally is the first to acquire a new piece of information not generally available to others in the market. But as Roll (1968) argues, in attempting to act immediately on this information, this individual will insure that the effects of this new information are quickly impounded in the security's price. Furthermore, if new information of this type arises randomly, no individual will be able to assure himself of systematic receipt of such information. Therefore, while an individual may occasionally realize such windfall returns, he will be unable to earn them systematically through time. While the weak form of the hypothesis is well substantiated by empirical evidence, the strong form of the hypothesis has not as yet been subjected to extensive empirical tests. The model developed in this paper allows us to submit the strong form of the hypothesis to such an empirical test - at least to the extent that its implications are manifested in the success or failure of one particular class of extremely well-endowed security analysts. I use the portfolio evaluation model developed here to examine the results achieved by the managers of 115 open end mutual funds. The main conclusions are: 1) The observed historical patterns of systematic risk and return for the mutual funds in the sample are consistent with the joint hypothesis that the capital asset pricing model is valid and that the mutual fund managers on average are unable to forecast future security prices. 2) If we assume that the capital asset pricing model is valid, then the empirical estimates of fund performance indicate that the fund portfolios were inferior after deduction of all management expenses and brokerage commissions generated in trading activity. When all management expenses and brokerage commissions are added back to the fund returns and the average cash balances of the funds are assumed to earn the riskless rate, the fund portfolios appeared to be just neutral. Thus, on the average the resources spent by the funds in to forecast security prices do not yield higher portfolio returns than those which could have been earned by equivalent risk portfolios selected (a) by random selection policies or (b) by combined investments in a market portfolio and government bonds. 3) I conclude that as far as these 115 mutual funds are concerned, prices of securities seem to behave according to the strong form of the efficient market hypothesis. That is, it appears that the current prices of securities completely capture the effects of all information available to these 115 mutual funds. Although these results certainly do not imply that the strong form of the hypothesis holds for all investors and for all time, they provide strong evidence in support of that hypothesis. 4) The evidence also indicates that, while the portfolios of the funds on the average are inferior and inefficient, this is due mainly to the generation of excessive expenses.
Weak form of efficient market hypothesis, Strong Form of Efficient Market Hypothesis, portfolio performance measurement
Abstract: It is important to avoid using 'perfection' as a criterion to judge scientific papers. Virtually all papers that make important contributions leave many questions unanswered and many even contain errors. It is also important to distinguish the criterion used to judge the scientific process as a whole from that used to judge individual papers. Complex phenomenon are mastered by the gradual development and linkage of models of sub-components of the system that of necessity are oversimplified and therefore only approximations to reality. Mathematics plays an important role in this process but much analysis and progress has to be accomplished in a new area before mathematics can be useful. Mathematics is not the same as 'rigor' and 'analysis' but it is often mistakenly identified as such. The tautologies or definitions chosen by scholars have important effects on the productivity of research efforts; yet these effects are generally unrecognized and unstudied. Indeed, in many quarters it is considered unscientific, or useless or even embarrassing to devote efforts to the consideration of tautologies.
Abstract: Within the context of a mean-variance equilibrium model of the pricing of capital assets, this paper investigates the allocation of investment in new risky opportunities which results from the collective behavior of firms, each of which attempts to maximize the net increase in its market value. This allocation is then compared to those allocations which (1) maximize nominal social wealth or (2) maximize social welfare. These comparisons are made under a variety of assumptions concerning the nature of the new opportunities, investor attitudes toward risk, and the number and characteristics of firms in the economy. With the exception of certain special cases, it is found that the private allocation of investment does not correspond to that which either maximizes social wealth or maximizes social welfare.
capital asset pricing, market value, social welfare, risk, capital markets, wealth maximization, corporate investment, Pareto optimality
Abstract: It is now difficult to launch a takeover against a Board willing to use the powers granted by the Unocal court to discriminate among shareholders. A determined Board could, in the extreme, pay out all the corporation's assets and leave the acquirer holding a worthless empty shell. The Unocal victory over Mesa cost the Unocal shareholders $1.1, the amount by which the Mesa offer exceeded the $8.3 billion value of Unocal's victory. This loss is 26% of Unocal's pre-takeover value of $6.2 billion. As of October 11 Unocal's value had declined by another $754 million. The $2.1 billion net increase in value to Unocal shareholders during the battle resulted from Unocal's $4.2 billion debt issue which, contrary to assertions, benefits its shareholders. It does so by bonding Unocal to pay out a substantial fraction of its huge cash flows to shareholders rather than to reinvest them in low-return projects, and by reducing taxes on Unocal and its shareholders. For his services in generating this $2.1 billion gain for Unocal shareholders, T. Boone Pickens has been vilified in the press, and Mesa Partners II has incurred net losses, before taxes. In addition to Mesa's losses, shareholders of all Delaware corporations lose because the court's decision gives management a weapon so powerful it essentially guarantees that no Delaware corporation that uses it will be taken over by a tender offer.
Unocal, Delaware Supreme Court, greenmail, benefit of takeovers, Mesa Partners, tender offer(s)
Abstract: This presentation is based on our (and our co-instructors’) work over the last six years in developing a course of the same title at the University of Rochester Simon School of Business (which course is now also taught at the US Air Force Academy, was recently delivered at the Erasmus Academie (Rotterdam), and a version of which is taught at the Erasmus University Law School, and will be taught at Texas A&M University). The course is designed to leave the participants being leaders and exercising leadership effectively as their natural self expression, and to contribute to creating a new science of leadership.
The course is founded on what we term an ontological model of human nature. The ontological approach is uniquely effective in providing actionable access to being a leader and exercising leadership effectively.
While ontology as a general subject is concerned with the being of anything, here we are concerned with the ontology of human beings (the nature and function of being for human beings). Specifically we are concerned with the ontology of leader and leadership (the nature and function of being for a leader and the actions of effective leadership). Who one is being when being a leader shapes one’s perceptions, emotions, creative imagination, thinking, planning, and consequently one’s actions in the exercise of leadership.
Being a leader and the effective exercise of leadership as one’s natural self-expression does not come from learning and trying to emulate the characteristics or styles of noteworthy leaders, or learning what leaders do and trying to emulate that (and certainly not from merely being in a leadership position, or position of authority).
If you are not being a leader, and you try to act like a leader, you are likely to fail. That’s called being inauthentic (playing a role or pretending to be a leader), deadly in any attempt to exercise leadership.
An epistemological mastery of a subject leaves you knowing. An ontological mastery of a subject leaves you being.
Gaining access to being a leader and the effective exercise of leadership as one’s natural self-expression also requires dealing with those factors present in all human beings that constrain each person’s freedom to be – and constrain and shape one’s perceptions, emotions, creative imagination, thinking, planning, and actions. When one is not constrained or shaped by these factors – what we term “ontological constraints” – one’s way of being and acting results naturally in one’s personal best in any leadership situation. We work with the students so that they accomplish this for themselves.
The Underlying Theory of the Course: Part I
• We work with the students to create for themselves what it is to be a leader, and what it is to exercise leadership effectively, as a context that uses them. By “a context that uses them”, we mean a context that has the power to leave students in any leadership situation being a leader and exercising leadership effectively as their natural self-expression. (As it has been said: “the context is decisive”.)
• By “a context that has the power to leave students being a leader and exercising leadership effectively as their natural self-expression”, we mean the following: a context that has the power in any leadership situation to shape the way in which the circumstances the students are dealing with occur for them such that their naturally correlated way of being and acting is one of being a leader and exercising leadership effectively. Note: being and action are always a correlate of the way in which the circumstances on which and in which a person is acting occur (show up) for that person.
• Students begin to create this context for themselves by first freeing themselves from the constraints and shaping imposed by their network of unexamined ideas, beliefs, biases, social and cultural embeddedness, and taken-for-granted assumptions relative to what it is to be a leader and what it is to exercise leadership effectively. This then allows students the freedom to create for themselves this new context for Leader and Leadership that has the power to become their natural self-expression.
• We give students access to creating this new context for leader and leadership by distinguishing Leader and Leadership from the perspective of four distinct aspects, which when taken together as a whole create this new context – the context that in any leadership situation shapes the way in which what is being dealt with occurs for the student such that their naturally correlated way of being and acting is one of being a leader and exercising leadership effectively.
We distinguish Leader and Leadership, each as: A Linguistic Abstraction (that creates a “realm of possibility”) A Phenomenon (what one observes or is impacted by) A Concept (the domain of leader and leadership) A Term (the definition of leader and leadership) All founded on Integrity (as a positive phenomenon) See: http://ssrn.com/abstract=920625
http://ssrn.com/abstract=932255
The Underlying Theory of the Course: Part II
• Ontological Constraints: Having distinguished what it is to be a leader, and what it is to exercise leadership effectively, as a context that has the power to give students the being of a leader and the actions of effective leadership as their natural self-expression, we provide students with exercises that allow them to become aware of and remove the ontological perceptual and functional constraints imposed on their natural self-expression.
• Ontological Perceptual Constraints: The source of our ontological perceptual constraints is our network of unexamined ideas, beliefs, biases, social and cultural embeddedness, and taken-for-granted assumptions about the world, others, and ourselves. These ontological perceptual constraints limit and shape what we perceive of what is actually there in the situations with which we are dealing. As a consequence, if we do not remove these perceptual constraints, then in any leadership situation we are left dealing with some distortion of the situation we are actually dealing with.
• Ontological Functional Constraints: In everyday language the behavior generated by an ontological functional constraint is sometimes referred to as a “knee-jerk reaction”. Psychologists sometimes refer to this behavior as “automatic stimulus/response behavior” – where, in the presence of a particular stimulus (trigger), the inevitable response is an automatic set way of being and acting. From a neuroscience perspective, many ontological functional constraints could be termed amygdala hijacks. When triggered in a leadership situation, one’s ontological functional constraints fixate one’s way of being and acting. Saying the same thing in another way, these ontological functional constraints limit and shape our opportunity set for being and action. As a consequence, the appropriate actions may be, and in fact often are, unavailable to us.
• Thus, gaining access to being a leader and the effective exercise of leadership requires that we loosen the grip of these debilitating Ontological Constraints. Or to put it more simply, we must take away what is in the way of our being a leader and exercising leadership effectively.
For the full paper see: http://ssrn.com/abstract=1238158
And for the full 478 pages of the course material used in the Erasmus Academie course June 8-12, 2009 see http://ssrn.com/abstract=1263835
Presented to: Canyon Partners, Los Angeles, CA, October 22, 2009; Simon School of Business Leadership Course, University of Rochester, Rochester, NY., July 22, 2009; Gruter Institute Squaw Valley Law, Brain and Behavior Conference, May 20, 2009; US Air Force Academy Center For Character and Leadership Development, Colorado Springs, April 30, 2009; and Olin School of Business, Washington University in St. Louis, and Cook School of Business, St. Louis University, St. Louis, MO, April 6, 2009.
Leadership, Ontology, Ontological Model of Human Nature, Ontological Constraints, Perceptual Constraints, Functional Constraints
Abstract: There is probably no concept so widely discussed and so dearly beloved as freedom, and yet so widely misunderstood. Freedom is something most of us want desperately for ourselves and we take great pride in claiming it as a characteristic of our society. Nevertheless, most of us have given little thought to what we mean by freedom. As a result, freedom ends up being used to describe virtually everything anyone anywhere classifies as good or right. Freedom is an hurrah word. Advocates of all ilks peddle whatever it is they are trying to sell under the guise of freedom. In the extreme, we find spokesmen for the most tyrannical states boldly claiming that theirs is the true freedom because they provide freedom from want - a logic, of course, perfectly equivalent to arguing that prisoners are free so long as they are well fed and have a roof over their heads. Let me say a few things about what freedom is not. -- Freedom is Not Political Democracy -- Freedom is Not Power -- Freedom is Not the Absence of Costs -- Freedom is hot the Absence of Coercion -- Freedom is Not the Absence of Constraints In fact freedom is a matter of social constraints. I define freedom in the following way: Maximum freedom exists in a society if (1) the rights system passes on to individuals the full set of opportunities provided by nature, and (2) the state enforces its monopoly over violence. We can now use these concepts to analyze the tradeoffs between freedom and efficiency in a number of controversial areas.
Abstract: Arbitragers provide important productive services to investors, and the supply of these services is threatened by the outpouring of self-righteous protests and legal actions in the wake of the SEC prosecution of insider trading cases. Current law, as interpreted by the SEC, fails to recognize that target shareholder interests are served by a legal rule that allows the producer of privately created information to share that information with others, including arbitragers. There is no economic basis for barring trading on this information so long as the information is legally obtained. When takeover bids occur, arbitragers provide valuable services for target-firm investors who do not have the time, ability or inclination to gather information on takeover bids for companies in which they hold stock. They help direct resources to their highest valued use. In doing so, the arbitragers provide three critically important services: they help value alternative offers, including the plans of target management; provide riskbearing services for investors who do not wish to bear the great uncertainty that occurs between the announcement and final outcome of a takeover bid or restructuring; and. help resolve the collective action or free rider problems of small diffuse shareholders who cannot organize to negotiate directly with competing bidders for the target firm. The arbitragers do this by aggregating large blocks of shares for tender to the highest bidder- sometimes even negotiating the offer price directly with the bidder.
Distinguishing between theft and sharing the results of private research
Abstract: This paper develops a theory of the press designed to explain why newspapers and other media protect their sources and certain public figures in some cases and expose personal facts about them in others. The theory suggests that the primary function of the news media is not to inform but to provide entertainment, and that this fundamentally affects what information is and is not presented to its consumers. Moreover, it provides the basis of a theory that explains media behavior in general. Keywords: Political Economy, News, Media, Manipulation, Bias
Political Economy, News, Media, Manipulation, Bias
Abstract: The discussion in Chapter 1 provides a useful general introduction to the subject of freedom. We continue in this chapter to analyze the details of applications of the Jensen-Meckling definition of freedom. We begin by addressing the following question: Why are the constraints that restaurant owners impose when they are given decision rights not themselves violations of freedom?
freedom, capitalism, concept of freedom, rights, markets, freedom of exchange, freedom of expression, politics and freedom, Constitution
Abstract: With the possible exception of love, probably no word in the English language generates a more sympathetic response than the word freedom. Everyone favors freedom. We prize it not only for ourselves, but also as a characteristic of our society. Most of us, however, have given little thought to what we mean by freedom. We use it to describe virtually everything we believe is good or right. Freedom is a hurrah word. Advocates of all persuasions characterize their programs as enhancing freedom. In the extreme, we find spokesmen for the most tyrannical states boldly claiming that theirs is true freedom because it provides freedom from want, a logic equivalent to arguing that prisoners are free as long as they are well fed and sheltered. Any unambiguous conception of freedom should distinguish between choices such as 1) Give me $20 and I'll give you a sirloin steak, and 2) Give me your wallet or I'll shoot you with the gun I have pointed at your midsection. These transactions both give you a choice. One might be tempted to say that the second is inconsistent with freedom because the choice I'm giving you makes you worse off. But there are many transactions that seem perfectly consistent with, and even required by, freedom that have this characteristic. Consider the offer I make you on the expiration of your lease of my property: Give me a monthly rental of 10% more than our previous arrangement or move out.
freedom, capitalism, human rights, definition of rights, nature, constraints, definition of freedom, contracts, power, rights
Abstract: This book covers three separate and related topics: the definition and analysis of freedom, the logical foundations of capitalism and a dualistic model of human behavior that incorporates both rational and non-rational action. I provide a new and clarifying view of each topic and analyze the deep interdependencies between them. Some of the intellectual foundations of this material were developed in conjunction with William Meckling who passed away last year. In the 1970's and 1980's while Bill and I were colleagues at the University of Rochester we spent much time considering the issues associated with the meaning of freedom and the difficulties of encouraging and obtaining effective peaceful cooperation among human beings. I believe Bill would sign on to much of what is contained in the first two parts of this book on freedom and capitalism. But he was not anxious to sign on to the implications of the work in the last decade by myself and others on the human brain and the non-rational behavior of human beings that is dealt with in Part III of this book.
freedom, capitalism, brain, behavior, special interests
Abstract: The basic problem in the conflict between political democrary and free markets is the following: individuals, you and I, can make ourselves and our families better off in two major ways: (1) By expending time and other resources operating in the private sector to produce goods and services (be they art, automobiles, film, or education) which other people wish to buy. (2) By expending our resources in the political sector to get the government to change the rules of the game to reallocate wealth from others in society to ourselves. In the first of these activities we generally make other people better off and in the second, we make them worse off: We make them worse off for two reasons: (1) The direct effects of the wealth transfers, and (2) The indirect effects caused by the reduced incentive to produceexamples include income taxes, restrictions on production such as our former farm programs and licensing restrictions on entry into various professions or markets, and the attenuation of property rights caused by significantly increased uncertainty over what will be the future rules of the game.
Political Economy, politics, markets, free enterprise
Abstract: Capitalism is far and away the most effective system ever invented for peacefully organizing cooperation among large numbers of human beings. The success enjoyed by capitalistic economies during the last 70 years is in sharp contrast to the dramatic and widespread failure of communist and socialist centrally planned closed economies. The economies (primarily in the West) organized more or less as capitalistic have created enormous wealth and living standards for their members, while virtually all others have resulted in impoverishment. And it is becoming clear that they have accomplished this with much less damage to the environment than non-capitalist societies. Moreover, the difference is not merely one of resource endowments. The current move toward more capitalist, open societies is drastically changing the world, and promises to go on for several generations. Because capitalism is widely misunderstood, it is paradoxically almost always under attack by those who would like to see societies organized in different ways. Private property capitalist systems are distinguished by the fact that most decision rights are assigned to private individuals or organizations. In contrast, socialist or communist systems assign most decision rights to the state or the governing party. This chapter identifies the essence of capitalism, and demonstrates its remarkably close relationship to the Jensen-Meckling concept of freedom explained in the first three chapters. To do this I first give a brief definition (without much discussion) of alienable decision rights, which are the foundations of ownership and capitalism. Then I discuss the role of knowledge in society, the essential nature of capitalism and what makes it work.
alienability, freedom, capitalism, decision rights, role of government, transfer costs, agency costs
Abstract: This article examines unrecognized implications of various doctrines governing access to court. The analysis indicates that doctrines such as standing, res judicata and collateral estoppel have far reaching implications for the nature of adjudication and the basic structure of rights in society. A liberal standing doctrine causes Peremptory Adjudication, creates inalienable rights and erodes the common law doctrine against suing competitors. Inalienability of rights causes the Coase Theorem to fail and creates externalities. Furthermore, allowing suit over non-contractual pure value effects creates closed market monopolies. All these factors reduce efficiency and thereby reduce human welfare. In this sense the analysis (1) indicates the widespread enthusiasm for democratization of the courts is mistaken, and (2) provides the case for restricting access to the courts.
standing, stare decisis, res judicata, collateral estoppel, Coase Theorem, courts, legal system, efficiency, adjudication, rights, externalities
Abstract: My congratulations and admiration to the Gruter Institute for Law and Behavioral Research and the scholars who have evidenced the courage to tackle a subject as difficult and opaque as the Gruter Institute Project on Values and Free Enterprise. With the support of the John Templeton Foundation, The UCLA-Sloan Research Foundation, and the Ann and Gordon Getty Foundation the volume they have produced, Moral Markets: The Critical Role of Values in the Economy, promises to be a landmark effort in bringing scientific inquiry and analysis to the normative world of values. Economics, being focused on the positive analysis of alternative institutional structures, has far too long ignored the normative world. The positive analysis of normative values may sound like a non-sequitor, yet it is in my opinion among the major issues facing the world today. It does not take much reflection or study of history to begin to see the import of different judgments about normative values on the tensions and conflicts among human beings. There are of course many causes underlying the conflicts between humans in addition to those involving differing value systems, including for example, power, wealth, etc. Nevertheless, the power of values (that is deeply held personal beliefs about what is good and bad behavior, what is desirable versus undesirable, what is 'right' vs 'wrong') to cause (or at least to encourage) human beings to commit the most horrific crimes against their neighbors is amazing: Witness the multitudes of religious and civil conflicts ranging from the crusades of the middle ages, the holocaust, two world wars, 'ethnic cleansing' in Bosnia, the mass killings of the Tutsis in Rwanda, to the civil wars, brutal bombings, torture and televised beheadings associated with the current worldwide conflicts involving radical Islam. A potentially valuable source of knowledge in discovering the source of these tensions and therefore in learning how to manage and reduce such tensions is a much deeper understanding of the role of values in shaping and guiding human action and interaction. And this clearly calls for a positive analysis of values, how they arise, how they change, how they interact across cultures, how they can be changed, and so on. Understanding how values are reflected in markets and how markets either reduce or increase their positive or negative effects on human welfare is clearly important. The work of the scholars represented in this volume makes important contributions to these issues and adds substantially to the foundations of analysis that will eventually lead to a richer and more complete understanding of these issues.
Positive Analysys of Nomative Values
Abstract: Why do we so often find the press carrying glowing stories of the benefits derived from governmental programs such as urban renewal (often-times even when they are in the process of failing miserably)? In view of this, why are we so seldom treated to glowing reports by the press about how a housing developer, for example, has improved the standard of living of 5,000 families by planning and completing a new subdivision of 5,000 homes? - a feat made no less remarkable (as compared to urban renewal) through its accomplishment by voluntary exchange! Or to put the issue in its starkest form: Why is it that the public at large is so basically antagonistic towards markets in general? There exists in many, if not most people, a deep seated belief that man should not be motivated by monetary rewards. This belief is reflected in many cultural traditions, one of which is called the Golden Rule. We believe a major element in the determination of these attitudes is the structure of the family, in particular the way in which we raise children and the reflection of these values in religious dogma.
Family, values, markets, Golden Rule, press
Abstract: The original cost regulatory system, as currently used in the regulation of utilities and natural gas pipelines, cannot emulate the response of a competitive firm to high and varying inflation. Although there can be many problems introduced by regulatory lag and by high administrative and hearing costs for all parties, these do not cause the difficulties we are concerned about here. The response of the original cost system to inflation, even when it is applied with no errors or lag, will be non-competitive, socially wasteful, and politically unsatisfactory. The system is conceptually flawed in a fundamental fashion that causes it to breakdown in times of high and varying inflation. It is possible to design a version of original cost regulation that responds appropriately to changes in expected inflation by using changes in interest rates, but such a system still won't deal properly with actual inflation when it differs from expected inflation. To emulate the response of a competitive return to actual inflation, we must use a version of original cost regulation that makes use of changes in a price index rather than changes in market interest rates.
regulatory systems, inflation, interest rates, price index, market rate
Abstract: No abstract available.
Abstract: Develops a theory of firm-ownership structure using elements from the theories of agency, property rights, and finance. The concept of agency costs is defined and its relationship to the "separation and control" issue is shown. In addition, the nature of the agency costs generated by debt and outside equity is investigated and both the individuals responsible for assuming these costs, and why they bear them, are identified. The evidence, demonstrated in the model used to explain the existence of minority shareholders and debt in the capital structure of corporations, implies that the owner-manager will have his entire wealth invested in the firm before he resorts to any outside funding. However, this evidence is not consistent with general observations of owner-managers--most owner-managers hold personal wealth in many forms and some invest only a fraction of their wealth in the corporation they manage. In addition, it is shown that the owner's fractional claim on the firm decreases as the amount of outside equity increases and that this causes the owner to take additional non-pecuniary benefits out of the firm because his share of the cost falls. Also, as the fraction of outside financing increases, the locus of agency costs shift upward. The agency cost of debt will rise similarly as the amount of outside financing increases. This leads to the hypothesis that, the larger the firm becomes, the larger the total agency costs because the monitoring function is likely to be more difficult and expensive in a larger organization. (SFL)
Agency costs, Operator ownership, Firm ownership, Organizational structures, Property rights, Debt financing, Capital structure, Organization theory, Agency theory, Firm financing, Shareholders
Abstract: SUBJECT AREAS: Leveraged buyouts; spin-offs; financial distress; control function of debt; corporate governance; boards of directors; LBO associations. CASE SETTING: 1987; USA (Wisconsin); railroad industry. REQUESTS FOR COPIES: To obtain a copy of this case, please contact Harvard Business School Publishing, 60 Harvard Way, Boston, MA 02163. Phone: (800) 545-7685. MAILTO:custserv@hbsp.harvard.edu, web:http://www.hbsp.harvard.edu or you may contact the author directly. Case No: 9-190-062, Wisconsin Central Ltd. Railroad and Berkshire Partners (A): Leveraged Buyouts and Financial Distress Case No: 9-190-070, Wisconsin Central Ltd. Railroad and Berkshire Partners (B): LBO Associations and Corporate Governance Case No: 9-891-509, Companion Video to A case: includes CEO of Wisconsin Central and Chairman of Berkshire Partners in Discussion with HBS Class Case No: 5-899-050, Teaching Note These cases provide an opportunity for students to understand the structure and operation of an LBO Association. Wisconsin Central Limited (WCL), formed in a 1987 leveraged buyout of 2,000 miles of unprofitable track from the Soo Line Railroad, is a regional railroad operating throughout Wisconsin and in parts of Minnesota, Illinois, and Michigan. For many years WCL has been the most profitable and highly rated railroad in the country. In the A case, there is conflict between the board of directors and the management of WCL over WCL?s response to the startup losses that caused its technical default. The policy disagreement is over whether WCL should try to grow its way out of the unexpected difficulties or respond by cutting costs. The main issues in the case, therefore, are: the nature of the conflict between WCL?s board and its management; and the role of WCL?s capital structure and division of equity holdings and governance structure in resolving the conflict. The B case describes the resolution of the default situation. It further examines the internal control mechanisms and distinct role of the board of directors of a typical LBO association. The teaching note provides instructors with detailed analysis of both the (A) and (B) cases, exploring the WCL buyout transaction, including strategy, valuation and capital structure, and the incentives of the major players in creating and resolving the conflict. The note includes cash flow projections for WCL, a suggested lesson plan for teaching the cases, and a transcript of a videotaped session held at Harvard Business School with WCL?s president and CEO, and a general partner of Berkshire Partners. Through the videotape, which serves as companion to the (A) case and is accompanied by a short viewing guide, students learn how differently these participants viewed the crisis at WCL, and how they were able to resolve the conflict in spite of their divergent views. This case series offers students an excellent opportunity to witness the control function of debt in action and highlights the important differences between traditional boards of directors, where equity ownership by directors is small, and LBO boards, whose members own significant amounts of stock. The series may be taught in conjunction with "Eclipse of the Public Corporation," by Michael C. Jensen (Harvard Business Review, September-October, 1989, Reprint No. 89504). These cases are currently taught in "Coodination and Control in Markets and Organizations," an elective course of about 600 students in the second year of the Harvard MBA program.
Abstract: SUBJECT AREAS: Leveraged buyouts; spin-offs; value creation; corporate governance; LBO associations. CASE SETTING: 1987; USA (Texas); commodity chemicals industry. Case No: 9-492-021, Gordon Cain and the Sterling Group (A) Case No: 9-492-022, Gordon Cain and the Sterling Group (B) Case No: 9-899-503, Companion Video to A case: includes Gordon Cain in Discussion with HBS Class Case No: 5-899-051, Teaching Note The Sterling Group, a Houston-based LBO firm led by entrepreneur Gordon Cain, forms Sterling Chemicals Inc. to purchase an ailing commodity chemicals plant from corporate giant Monsanto. Because of dramatically increased organizational performance and rising styrene prices, the firm generates huge increases in value. Sterling?s success bred conflict, however, in the form of pressure from managers and employees to liquefy their large, undiversified equity holdings. This pressure threatens to undo the very structure that led to success. As background, the (A) case recounts the story of Cain Chemical Inc., also created by Sterling through a series of leveraged acquisitions of petrochemical plants and pipelines along the Texas Gulf Coast. The case explores the relative contributions of rising chemicals prices and organizational changes to value creation, the wealth effects of the value change to employees, and Cain?s eventual decision to sell the company to a conglomerate to gain the desired liquidity at a profit equal to 45 times the initial equity investment. The follow-up (B) case reveals Sterling Chemicals? decision to go public, and provides a brief synopsis of its IPO, and post-IPO performance which includes complete repayment of the LBO debt, large profit sharing payments to employees (who share in excess EBDIT), and huge cash dividends to equity holders. The companion videotape shows Gordon Cain discussing his experiences at Sterling and Cain Chemical with Harvard MBA students. This case series allows students to examine the causes of organizational change, the difficulties of managing success in closely held LBO companies, and the relative merits of various exit strategies. These cases are currently taught in "Coodination and Control in Markets and Organizations," an elective course in the second year of the Harvard MBA program. The series may be taught in conjunction with "Eclipse of the Public Corporation," by Michael C. Jensen (Harvard Business Review, September-October, 1989, Reprint No. 89504). These cases are currently taught in "Coodination and Control in Markets and Organizations," an elective course of about 600 students in the second year of the Harvard MBA program.
Abstract: The course Coordination, Control and the Management of Organizations (CCMO) was initiated at the University of Rochester in 1973 by Michael C. Jensen and William H. Meckling. This course became one of the most highly demanded courses at the Simon School of Business and at the Harvard Business School (after it was ported to HBS by Jensen in 1985). As an elective in the second year of the Harvard MBA program, the course regularly attracts between 500 and 600 of the 850 second-year students. At HBS, Karen H. Wruck played a major role in bringing new ideas and materials to the course, especially in the area of corporate governance and control, and in her contributions to the course architecture. CCMO presents a new theory of organizations that draws on economics, finance, psychology, neuroscience, and human resource management. CCMO is taught by the Organizations & Markets (O&M) Unit at the Harvard Business School which is devoted to the interdisciplinary development of a modern theory of organizations and markets that is useful both to social scientists and managers. The faculty who regularly teach the course are: Michael C. Jensen, George P. Baker, Karen H. Wruck, Carliss Y. Baldwin, and Malcom S. Salter. In developing our theory, we focus particularly on four interrelated areas: 1) the nature of human beings and their behavior; 2) compensation, career systems, and performance measurement; 3) task structure, organizational boundaries, and technology; and 4) governance, corporate finance, and organizational performance. The CCMO materials are presented in four electronic documents entitled as follows (you can go directly to each document and its abstract by clicking on the title below): 1. Organizations and Markets: History and Development of the Course and the Field, by Michael C. Jensen, George P. Baker, Carliss Y. Baldwin, and Karen H. Wruck, Dec. 10, 1997 (forthcoming in "The Intellectual Venture Capitalist: John H. McArthur and the Work of the Harvard Business School," 1980-1995, Thomas K. McCraw and Jeffrey L. Cruickshank, eds, (Harvard Business School Press, 1998). 2. Coordination, Control, and the Management of Organizations: Course Notes, by Michael C. Jensen and William H. Meckling, with contributions from George P. Baker and Karen H. Wruck, April 20, 1998, Harvard Business School Working Paper #98-098. 3. Coordination, Control, and the Management of Organizations: Course Content and Materials, by Michael C. Jensen and Karen H. Wruck, April 20, 1998, unpublished manuscript, Harvard Business School. 4. Coordination, Control, and the Management of Organizations: Practice Questions, by Michael C. Jensen, William H. Meckling, George P. Baker, and Karen H. Wruck, with contributions from Carliss Y. Baldwin, and Malcolm S. Salter, April 20, 1998, unpublished manuscript, Harvard Business School.
Abstract: We present a positive model of integrity that, as we distinguish and define integrity, provides powerful access to increased performance for individuals, groups, organizations, and societies. Our model reveals the causal link between integrity and increased performance, quality of life, and value-creation for all entities, and provides access to that causal link. Integrity is thus a factor of production as important as knowledge and technology, yet its major role in productivity and performance has been largely hidden or unnoticed, or even ignored by economists and others.
For an individual we distinguish integrity as a matter of that person's word being whole and complete. For a group or organizational entity we define integrity as that group's or organization's word being whole and complete. A group's or organization's word consists of what is said between the people in that group or organization, and what is said by or on behalf of the group or organization. In that context, we define integrity for an individual, group, or organization as: honoring one's word.
Oversimplifying somewhat, honoring your word, as we define it, means you either keep your word, or as soon as you know that you will not, you say that you will not be keeping your word to those who were counting on your word and clean up any mess you caused by not keeping your word. By keeping your word we mean doing what you said you would do and by the time you said you would do it.
Regarding the relationship between integrity, and the three virtue phenomena of morality, ethics and legality, this new model: 1) encompasses all four terms in one consistent theory, 2) makes clear and unambiguous the moral compasses potentially available in each of the three virtue phenomena, and 3) by revealing the relationship between honoring the standards of the three virtue phenomena and performance (including being complete as a person and the quality of life), raises the likelihood that the now clear moral compasses can actually shape human behavior. This all falls out primarily from the unique treatment of integrity in our model as a purely positive phenomenon, independent of normative value judgments.
In summary, we show that defining integrity as honoring one's word (as we have defined honoring one's word): 1) provides an unambiguous and actionable access to the opportunity for superior performance and competitive advantage at both the individual and organizational level, and 2) empowers the three virtue phenomena of morality, ethics and legality.
integrity, trust, values, ethics, corporate fraud, trustworthy, economic cost benefit analysis
Abstract: High-debt ratios that factor in leveraged buy-outs, recapitalizations, highly leveraged mergers and stock repurchases are a source of concern in the press and public-policy circles. Yet they can be a virtue because they provide strong incentives for efficiency, even where the specter of bankruptcy is concerned. Even where bankruptcy does occur, debt and insolvency can serve a very important control function to replace what seems to be the failed model in which the public board of directors monitors management and its strategy directly. The recent case of Revco, the largest LBO to go into bankruptcy, exemplifies this point. The deal may have been poorly structured to begin with. In addition, however, Revco managers pursued a strategy to upgrade the company's drugstores to department stores. The strategy failed, but the high debt load prevented Revco from pursuing the flawed project for long because insolvency and bankruptcy allowed the creditors and owners to replace managers and facilitate abandonment of the strategy. Such rapid change in management and strategy is highly unlikely to occur under the usual public-director/low-leverage control model of the typical American corporation.
Insolvency, bankruptcy, efficiency
Abstract: Postscript: This was written as part of the Harvard Business School Leadership and Learning effort, a wide-ranging review and evaluation of the HBS curriculum. After submitting my earlier comments entitled Toughmindedness, Courage, and Change, to the HBS Curriculum Core Design Team, I had occasion to re-read Because Wisdom Can't Be Told, by Charles I. Gragg (1940). This discussion of learning and the role of the case method seems to serve as the basis of many of the ideas at HBS about learning. There is much in it that I agree with wholeheartedly. But there is a glaring omission that may be the source of some strain in our system over what the case method is, or should be. Gragg (1940, p. 3) defines the objective of the business school and case method as follows: The work of a graduate school of business consequently must be aimed at fitting students for administrative positions of importance. The qualities needed by business people in such positions are: the ability to see vividly the potential meanings and relationships of facts, both those facts having to do with persons and those having to do with things; capacity to make sound judgments on the basis of these perceptions; and skill in communicating their judgments to others so as to produce the desired results in the field of action. Business education, then, must be directed to developing in students these qualities of understanding, judgment, and communication leading to action. Gragg leaves out a critical part of what must be a theory of learning in the case or any other method: that is the criteria to be used in deciding what is correct, or in his words the criteria to be used in making sound judgments. I believe the answer to this is scientific method, the process by which we state our theories of cause and effect relationships and by which we test whether they actually describe the way the world behaves. As pointed out in my earlier paper, all purposeful behavior requires the use, either explicitly or implicitly, of theories that define the relation between actions and outcomes. Thus, I conclude there is no other answer to the criteria for use in making sound judgments other than science. This simple addition to the notion of the case method preserves all its motivational and learning advantages, while providing a clear criteria or process that has been tested for centuries for eliminating error. I think about the problem not as what the case method should be, but the problem of trying to discover the most effective ways to provide an environment in which students can learn. By learning, I mean a set of experiences that changes people's actions, gives them knowledge and behavior patterns that enable them to better run their lives (including their businesses), and to continue to learn outside of the classroom. This involves a theory of learning.
case method teaching, theory of learning, scientific method and case teaching, Harvard Business School curriculum design, judgment
Abstract: Thus far we have seen that the corporate takeover phenomenon of the 1980s was one with roots deep in the history of U.S. managerial capitalism, and that the scientific evidence on takeovers shows clearly that they have generated enormous efficiency gains by forcing the restructuring of many firms in mature and declining industries - firms which were often awash in (and systematically wasting) corporate free cash flow. In this chapter we will examine the legal regulatory environment that shaped the market for corporate control during the 1980s, and its legacy for today's control market. I begin below with a discussion of the legal doctrine underlying key 1980s takeover-related rulings of the Delaware courts and its implications for the corporate control market and the corporate form of organization.
corporate takeovers, restructuring, free cash flow, market for corporate control, legal doctrine, Delaware courts, Agency Model, poison pills, tender offers
Abstract: Corporate America is being restructured at a rapid pace. This restructuring is being accomplished through a variety of transactions in the market for corporate control and through voluntary actions of managers as they rationalize and refocus the firms they lead. These events take the form of hostile takeovers, voluntary mergers, leveraged buyouts, stockholder buyouts, spinoffs, split-ups, divestitures, asset sales and liquidations. In the last two years merger and acquisition activity has run at the rate of $180 billion in over 3,000 transactions per year. Last year over 1,200 of these transactions valued at over $45 billion were divestitures - sales of divisions by many of our largest corporations. This explains why these control transactions have not increased the concentration of economic power in large corporations. Restructurings are frequently wrenching events in the lives of those linked to the involved organizations - the managers, employees, suppliers, customers and residents of surrounding communities. Restructurings usually involve transfers of ownership, and major organizational changes (such as shifts in corporate strategy) to meet new competition or market conditions, increased use of debt, and a flurry of recontracting with managers, employees, suppliers and customers. This activity sometimes results in expansion of resources devoted to certain areas and at other times in contractions involving plant closings, layoffs of top-level and middle managers, staff and production workers, and reduced compensation.
Corporate restructuring, divestitures, mergers & acquisitions, corporate control, takeovers, restructuring as a defense
Abstract: Corporate America is being restructured at a rapid pace. This restructuring is being accomplished through a variety of transactions in the market for corporate control and through voluntary actions of managers as they rationalize and refocus the firms they lead. These events take the form of hostile takeovers, voluntary mergers, leveraged buyouts, stockholder buyouts, spin-offs, split-ups, divestitures, asset sales, and liquidations. In the last two years merger and acquisition activity has run at the rate of $180 billion in over 3,000 transactions per year. Last year over 1,200 of these transactions valued at over $45 billion were divestitures - sales of divisions by many of our largest corporations. This explains why these control transactions have not increased the concentration of economic power in large corporations. Restructurings are frequently wrenching events in the lives of those linked to the involved organizations - the managers, employees, suppliers, customers and residents of surrounding communities. Restructurings usually involve transfers of ownership and major organizational changes (such as shifts in corporate strategy) to meet new competition or market conditions, increased use of debt, and a flurry of recontracting with managers, employees, suppliers and customers. This activity sometimes results in expansion of resources devoted to certain areas and at other times in contractions involving plant closing, layoff of top-level and middle managers, staff and production workers, and reduced compensation.
Abstract: The Third Industrial Revolution that began in 1973 promises increased productivity, large reductions in the world-wide inequality of wealth, and substantial increases in world-wide living standards. The immediate sources of the changes are large increases in capacity and productivity resulting from major political and technological progress. The political dynamic behind this Third Industrial Revolution is the spread of capitalism in response to the world-wide failure of communism, socialism and other central planning systems. This move to market-oriented, open economic systems is putting 1.2 billion Third World workers into world product and labor markets over the next generation. Over a billion of these workers currently earn less than $3 a day, while the approximately 250 million workers in the U.S. and the European Union currently earn $85 a day. With relatively modern technology, experience indicates that these Third World workers can produce from 85% to 100% of the output of their Western compatriots. The major shifts in the world product markets brought about by the 90 million workers in Hong Kong, Japan, Korea, Malaysia, Singapore and Taiwan in the past 30 years provide some insight into the even greater changes that are yet to take place in the West. One can confidently forecast that the transition to open capitalist economies will generate great conflict over international trade as special interests try to insulate themselves from competition. The transition of established industrial economies will require a major redirection of Western labor and capital to activities where it has a comparative advantage. The upshot of all this for Western workers is that their real wages are likely to continue their sluggish growth and some will fall dramatically over the coming two or three decades, perhaps as much as 50% in some sectors. Wages will, however, reach a trough and recover as the cycle works its way through the system. Remember, these 1.2 billion Third World workers and their families represent huge new markets as well as competitors.
Abstract: The controversy surrounding the so-called LBO issue is a mystery to me because the facts reveal no evidence of a problem. Congressman Markey has said that he wasn't considering a bill to restrict, regulate, or oversee MBOs, and I encourage him to continue down that path. I recommend that Mr. Markey consider adopting for his legislative program one of the principles on which I run my life: If you never miss an airplane, you're getting to the airport too early. I urge his sub-committee not to arrive at the airport the day before the flight's departure, which, in spite of what he says, is what may happen with MBOs. Congressional legislators rarely schedule hearings with the idea that they will do nothing. We should wait to see more than a few LBOs in trouble before we start thinking about further restricting a system that has worked well.
LBOs, MBOs, restrictions, monitoring institutions, banks, SEC
Abstract: Microsoft recently doubled its dividend and will pay out about $1.7bn to shareholders of record on November 7. It joins 1,000 other US companies that have either instituted or increased dividends this year. While most observers have focused on the policy considerations that have sparked this trend - specifically the decrease in marginal tax rates on dividend income in the US - they have missed another, equally important, implication. Dividend policy remains a critical, yet often neglected, weapon in the battle to reduce agency costs. Agency costs arise when the interests of managers and the interests of shareholders diverge. Such tensions can arise on issues ranging from the nature and level of executive compensation to the rate at which executives reinvest profits. While such divergence can play itself out dramatically, as in the case of Enron, it often manifests itself in far more mundane issues, such as whether a company should be predisposed to return funds to shareholders or predisposed to invest them in expanding the company. Dividend policy, although rarely viewed in this light, represents an important tool for those seeking to realign the incentives of managers with those of shareholders.
Free cash flow, Agency costs, Reinvestment policy, governance
Abstract: Shareholders, taxpayers, consumers and voters must be wary of wolves dressed in sheepskin currently attacking executive compensation to achieve their own ends. Many assert that executives are overpaid and paid in a way that is independent of performance. Noteworthy is the lack of accusation of fraud or illegal behavior. Most important, the attack has excited little support on the part of shareholders, who, after all, pay the bill. Shareholders recognize that there is no issue, a conclusion supported by the best scientific evidence currently available. The consensus of more than 60 leading academicians at a recent University of Rochester conference was that executive salaries are determined by the market, and that changes in compensation are strongly related to company performance. Moreover, no one expressed concern that compensation was too high.
CEO Compensation, executive compensation, corruption, fraud
Abstract: We meet in the midst of a nation brought to the verge of moral, political, and material ruin. . . . The fruits of the toil of millions are boldly stolen to build up colossal fortunes for the few, unprecedented in the history of mankind; and the possessors of these, in turn, despise the republic and endanger liberty. From the same prolific womb of government injustices are bred two great classes of tramps and millionaires. This quote could have been lifted from yet another television drama disparaging the boom years of the 1980s. In fact, it comes from the Populist Party platform adopted at the party's first convention in Omaha, Neb., on July 4, 1892. Just as the takeover specialists of the 1980s have been condemned by managers, policy makers and the press, the so-called Robber Barons of the 19th century were similarly vilified. But like their Populist predecessors, the anti-greed pundits of the 1990s have missed a far larger phenomenon. We are today in the midst of a third industrial revolution, comparable in scope to the previous two - the first having occurred in England from the late 18th through the early 19th centuries, and the second taking place primarily in the U.S. from the mid- to the late 19th century. Revolutions such as these lead to steadily rising productivity, dramatic reductions in labor costs and significant increases in living standards. Many industries experience substantial excess capacity as fundamental technological, political, regulatory and economic forces radically change the global competitive environment. The merger booms of the 1890s and the 1980s played a major role in helping industries restructure, thus speeding the adjustment to the new business environment. While these revolutions brought prosperity, the large costs associated with the obsolescence of human and physical capital in certain industries generated substantial hardship, misunderstanding and bitterness. In both the 19th and 20th centuries, criticism on the part of those who could not or would not adjust to modernization was followed by public policy changes that restricted the capital markets: in the 19th century, through the passage of antitrust laws restricting combinations; in the late 1980s, with the re-regulation of the credit markets, antitakeover legislation and restrictive court decisions. These restrictions were based on specious claims about economic decline that are in complete conflict with the data now available.
Third Industrial Revolution, Leveraged Buyouts, Takeovers, Restructuring, Downsizing, Excess Capacity, Mergers, Incentives, Productivity, Regulation
Abstract: After slackening off during the recent market crash, takeovers are picking up. As a result, anti-takeover activity is due for a second wind as well. Congressional Democrats, eager to please the CEOs of some of our largest and worst-run corporations, are engaged in several tax and regulatory efforts. Existing requirements that purchasers disclose their holdings and intentions within 10 days of acquiring 5% or more of a company's shares already discourage tender offers unduly by creating free-rider problems. These onerous strictures would be tightened if Sen. William Proxmire's bill to further regulate tenders is passed. Under current law, purchasers who reach the 5% trigger point are required to file within 10 days a 13d report with the Securities and Exchange Commission, disclosing the identity of the owner, the number of shares owned, and the purpose of the acquisition. The Proxmire bill would require the 13d to be filed within five days of acquisition of 5% of a firm's shares and would prohibit further acquisition of shares until the 13d is filed. While disclosure rules may appear to benefit shareholders by giving them quick access to valuable information, in fact they fundamentally damage both shareholders and security markets. Disclosure requirements are the security market's equivalent of an anti-patent law. They effectively deny private rights in valuable, privately produced information by forcing the producer to make that information public in a way that harms his interests. By doing so the regulations substantially reduce individual incentives to produce information. How does this happen?
tender offers, Proxmire Bill, regulation, SEC, disclosure, 13d reporting, free rider problems, market for corporate control
Abstract: Arbitragers provide important productive services to investors, and the supply of these services is threatened by the current outpouring of self-righteousness and legal action in the wake of the Securities and Exchange Commission's prosecution of Ivan Boesky and others accused of insider trading. When takeover bids occur, arbs provide valuable services for target-firm investors who do not have the time, ability or inclination to gather information on takeover bids for companies in which they hold stock. Arbs help direct resources to their highest-valued use. In doing so, the arbs provide three critically important services: 1) they help value alternative offers (including the plans of target management), 2) they provide risk-bearing services for investors who do not wish to bear the great uncertainty that occurs between the announcement and final outcome of a takeover bid or restructuring, and 3) they help resolve the collective action or freerider problems of small, diffuse shareholders who cannot organize to negotiate directly with competing bidders for the target firm. The arbs do this by aggregating large blocks of shares for tender to the highest bidder and sometimes even negotiating with the bidder directly over the offer price. The third situation occurs when an individual produces valuable information and voluntarily shares it or sells it to others. Daniel Fischel of the University of Chicago Law School notes that this sharing of information is no different from any other exchange and should not be prohibited. After expending resources to produce valuable information for themselves about how a target company can be restructured to create value, takeover specialists can rationally decide to share that information with others prior to releasing it to the public. In this case trading on such shared information damages no one, and if such sharing is prohibited or discouraged as under current SEC policy, the very investors the SEC seeks to protect (non-insiders) will be harmed.
Arbitragers, information, takeover bids, target shareholder interest, SEC, risk-bearing services, insider trading, legality of sharing of information
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