SOLUTIONS & INSTRUCTORS MANUAL for Corporate Governance 1st Edition by Marc Goergen. ISBN 9781473759 by StudyGuide

Instructor Manual International Corporate Governance First edition

Marc Goergen

Contents Chapters Part I

Pages Introduction to Corporate Governance

Defining corporate governance and key theoretical models

Corporate control across the world

Control versus ownership rights

International Corporate Governance

Taxonomies of corporate governance systems

Incentivising managers and disciplining of badly performing managers

Corporate governance, types of financial systems and economic growth

Corporate governance regulation in an international context

Corporate Governance and Stakeholders

Corporate social responsibility and socially responsible investment

Debtholders

10.

Employee rights and voice across corporate governance systems

11.

The role of gatekeepers in corporate governance

Improving Corporate Governance

12.

Corporate governance in emerging markets

13.

Contractual corporate governance

14.

Corporate governance in initial public offerings

15.

Behavioural biases and corporate governance

Part II

Part III

Part IV

3 © Pearson Education Limited 2012

PART I

Introduction to Corporate Governance

5 © Pearson Education Limited 2012

CHAPTER 1

Defining corporate governance and key theoretical models Discussion questions 1. Discuss Andrei Shleifer and Robert Vishny’s definition of corporate governance. What is their rationale for attributing a special status to the providers of finance compared to other corporate stakeholders? Shleifer and Vishny justify the special status of the providers of finance, in particular shareholders, by the fact that while all other stakeholders can easily recuperate their investment in the firm when the firm runs into trouble, shareholders typically lose their investment. In other words, shareholders are the residual claimants and their claims will only be met once the claims of all the other stakeholders have been met. Hence, their claims have the least protection and shareholders face the highest risk of being expropriated by the management. 2. Compare the principal–agent problem of equity with that of debt. The principal–agent problem of equity relates to conflicts of interests between the management and the shareholders. While it is the management’s duty to run the company in the interest of the shareholders, they may prefer to pursue their own objectives. Possible agency costs caused by conflicts between the managers and shareholders include empire building and excessive perquisites. The principal–agent problem of debt concerns conflicts of interests between the shareholders and the debtholders. If the firm is mainly financed by debt and/or close to financial distress, the shareholders may be tempted to gamble with the debtholders’ money by investing in high-risk projects. If these projects are successful, the shareholders will reap most of the payoff as the debtholders’ claims are capped, i.e. at best the debtholders will get their money back including any interest agreed upon. However, if the projects fail, the debtholders will bear most of the costs. While the principal–agent problem of equity is about the firm not being run in ways to maximise shareholder value, the principal–agent problem of debt assumes that shareholders are in control and they may end of expropriating the other providers of finance, i.e. the debtholders. 3. What is the difference between ownership and control? Why do differences between the two matter? Ownership is defined as ownership of cash flow rights whereas control is the ownership of voting rights. A cash flow right gives its holder a pro rata share in the firm’s cash flows or profit, whereas control confers rights such as the right to appoint the members of the board of directors at the annual general shareholders’ meeting. Ownership is not necessarily identical to control as, e.g. some shares do not confer any control rights. It is important to be aware of differences between ownership and control as they determine the types of conflicts of interests that are likely to prevail in particular national corporate governance systems or individual companies.

6 © Pearson Education Limited 2012

Goergen, International Corporate Governance, 1st edition, Instructor’s Manual

4. What are the potential weaknesses of mutual organisations compared to stock corporations in the area of corporate governance? One of the weaknesses of mutual organisations is that it is difficult to mitigate the principal– agent problem, given that disciplinary and incentivising mechanisms such as the market for corporate control, monitoring by large shareholders and stock options are not available. As each member has only one vote, independent of their stake in the organisation, this prevents the emergence of large owners that are powerful enough to have a strong hold on the management. Another important weakness of mutual organisations is that there is no share price that tends to give a more objective view of the management’s performance than accounting profits that can be easily manipulated.

Exercises 1. Calculate the percentage of ownership that Edwina Scissor holds in Sheffield Scissor Sisters Plc (see Figure 1.6). Assuming that Edwina Scissor has effective control of each of the firms in the ownership pyramid, including Sheffield Scissor Sisters Plc, what would be the percentage of shares that Edwina Scissor holds in Scissor Sisters Assets Ltd that would just about not make it worthwhile for her to steal from Sheffield Scissor Sisters Plc?

Figure 1.6 Edwina Scissor Edwina Scissor

58% Sharp Edge Holdings Ltd

X% Scissor Sisters Assets Ltd

50.5% Blades Holdings Ltd

29% Sheffield Scissor Sisters Plc Edwina Scissor’s ownership in Sheffield Scissor Sisters plc amounts to 8.49%, i.e. 58% of 50.5% of 29%. Hence, if Edwina steals one pound from Sheffield Scissor Sisters plc, the net gain from doing so will amount to about 91.51 pence and the costs will be 8.49 pence.

7 © Pearson Education Limited 2012

Goergen, International Corporate Governance, 1st edition, Instructor’s Manual

In order to recoup her costs, Edwina will need to hold a stake of at least 8.49% in Scissor Sisters Assets Ltd. A stake of 8.49% will generate a gain at the level of Scissor Sisters Assets Ltd of exactly her cost of 8.49 pence from stealing one pound from Sheffield Scissor Sisters Plc. 2. Based on Figure 1.7, calculate the losses to the minority shareholders of Mueller Holding Company and those of Mueller Cake Factory Inc. if Arthur Mueller III senior were to transfer for free oven equipment for a value of US$5m to Monaco-Mueller Investment Fund S.A. Assume that Arthur Mueller III senior has effective control of Mueller Cake Factory Inc. via the 25% held by the Mueller Holding Company.

Figure 1.7 Holdings of Arthur Mueller III, senior

Arthur Mueller III, senior

75% Mueller Holding Company

100% MonacoMueller Investment Fund S.A.

25% Mueller Cake Factory Inc.

The losses to the minority shareholders of Mueller Cake Factory Inc. amount to 75% of US$5m, i.e. US$3.75m. The losses to the minority shareholders of Mueller Holding Company add up to 25% of 25% of US$5m, i.e. $312,500. The sum of these losses amounts to £4,062,500. The remaining cost of $937,500 will occur to Arthur Mueller and his net gain will be equal to the losses of £4,062,500 suffered by the minority shareholders of Mueller Cake Factory Inc. and Mueller Holding Company.

8 © Pearson Education Limited 2012

CHAPTER 2

Corporate control across the world Discussion questions 1. Compare corporate control in the UK and the USA to corporate control in the rest of the world. What can you say about the levels of control across the world? How do the different types of large shareholders vary across the world? Corporate control in the UK and the USA is highly dispersed with only few stock-exchange-listed firms having large shareholders. Consequently, control lies with the management rather than with the shareholders and the main conflict of interests is the classical principal–agent problem between the managers and the shareholders. The main types of large shareholders in the UK and the USA are institutional shareholders and the directors themselves. In contrast, in most other countries, control is highly concentrated in the hands of one or a few shareholders. Important types of shareholders are holding companies and other corporations, families, governments and banks. However, there are some countries that do not conform to the above patterns. For example, in Asia, Japan and Korea have a relatively low concentration of control. In Continental Europe, France and the Netherlands stick out; the former has relatively high control held by banks and the latter has high levels of control by institutional investors. 2. How does corporate control in Japan and Korea compare to the rest of Asia? Although control in most of Asia is in the hands of families and governments, Japan and Korea have a relatively low concentration of control. In addition, stakes held by institutional shareholders in Japan and Korea tend to be small and do not normally exceed 10%, whereas this is not the case in the rest of Asia where institutional shareholders typically hold stakes in excess of 20%. 3. What are keiretsus and chaebols? Keiretsus are Japanese groups of industrial companies with close ties to a single bank and with cross-holdings between the individual companies in a group. The bank typically acts as the main lender to the group. Keiretsus originated from the pre-WWII zaibatsus, which were industrial groups, including a bank, controlled by families via a holding company at the top of the group. In contrast, apart from the relatively small cross-holdings between the various companies forming the group, keiretsus tend to be widely held. Chaebols are Korea’s version of the Japanese keiretsu. They are industrial groups controlled by families.

9 © Pearson Education Limited 2012

CHAPTER 3

Control versus ownership rights Discussion questions 1. Adolf Berle and Gardiner Means argued that, as companies become large, they experience a separation of ownership and control. For each of the four combinations of ownership and control reviewed in this chapter determine whether there is a separation of ownership and control and identify those that are in control and those that own the corporation. The four combinations are as follows: (A) weak control and dispersed ownership, (B) strong control and dispersed ownership, (C) weak control and concentrated ownership and (D) strong control and concentrated ownership. Berle and Means’ description refers to combination A where ownership is dispersed and shareholder control is weak and control lies effectively with the management. Combination A applies to most UK and US corporations. Combination B applies to most corporations outside the UK and the USA. Effectively, this combination consists of a separation of ownership and control, but not in the Berle–Means sense as control lies with a large shareholder that has a relatively low ownership stake. While the large shareholder is in control, most of the firm’s cash flow rights are owned by the small shareholders. Combination C is fairly rare and only applies to a few firms with voting caps in place. While ownership may be concentrated, the percentage of votes that can be exercised by an individual shareholder is capped and the concentration of control is therefore relatively low. As a result, control lies with the management. Finally, combination D refers to companies with a large shareholder that owns a large proportion of both the control rights and the cash flow rights. This combination is characterised by very little separation between ownership and control. 2. ‘Most stock-market listed companies in continental Europe are characterized by strong control and concentrated ownership.’ (Anonymous) Discuss the validity of the above statement. The above statement is clearly not valid, given that most corporations in continental Europe are characterised by strong control, but dispersed ownership. Large shareholders are able to leverage their ownership via a series of devices including ownership pyramids, dual-class shares, voting coalitions, proxy votes and clauses in the articles of association conferring additional voting rights to long-term shareholders. 3. Discuss the devices that make control different from ownership. What impact do differences between ownership and control have on the conflicts of interest that are likely to prevail in a corporation? Large shareholders are able to maintain control and reduce their ownership via ownership pyramids, the issue of dual-class shares, the forming of voting coalitions with other shareholders, the exercise of proxy votes and clauses in the articles of association conferring them additional voting rights for their long-term relationship with the firm. In turn, managers can increase their control over the firm by soliciting proxy votes from their shareholders, and by setting up voting cap and cross-shareholdings.

10 © Pearson Education Limited 2012

Goergen, International Corporate Governance, 1st edition, Instructor’s Manual

The higher the percentage of votes held by the large shareholder compared to the percentage of cash flow rights he/she holds, the higher will be the danger of minority-shareholder expropriation. Managers who manage to solicit proxy votes or put voting caps or crossshareholdings in place are more likely to become entrenched and become immune to shareholder interventions and hostile takeover bids.

Exercises 1. Base yourself on the example in Box 3.5. a) Determine the ownership the Agnelli family has in La Rinascente, a chain of Italian department stores. The Agnelli own less than 8% of La Rinascente. b) Spot the incidences of cross-holdings or interlocks. These were defined in Chapter 2. As a reminder, they consist of two companies holding shares in each other. What are the possible corporate governance implications of these cross-holdings? There is a cross-holding between Somal and Worms. Somal holds a stake of 97.2% in Worms and in turn the latter holds a stake of 28.2% in Somal. Typically, cross-holdings are set up by the management teams of the two companies involved to protect each other from hostile takeovers and other disciplinary actions by shareholders and the stock market. As a consequence, managers are likely to become entrenched and may no longer run the firm in the interests of the shareholders. However, the Somal–Worms case is somewhat more complex as Somal has a majority shareholder, i.e. IFIL, which is ultimately controlled by the Agnelli family. Effectively, IFIL holds a supermajority in Somal via Worms’ 28.2% in Somal. 2. There is something interesting going on in terms of the relative importance of common stock over 2008 and 2009 in Ford Motor Company (see Box 3.7). Have you spotted it? What are the implications? Common stock has increased by about 43.5% from 2008 to 2009 while the percentage of votes on common stock has remained at 60%. This implies that ownership by class B stockholders has fallen from 4.2% in 2008 to slightly over 3% in 2009. Hence, the Ford family has managed to keep the same degree of control while further leveraging its ownership.

11 © Pearson Education Limited 2012

PART II

International Corporate Governance

12 © Pearson Education Limited 2012

CHAPTER 4

Taxonomies of corporate governance systems Discussion questions 1. Compare the assumptions and the predictions of the varieties of capitalism (VOC) literature with those of the law and finance literature. The taxonomies based on the law and finance literature typically assume a hierarchy of institutions whereby systems with highly developed stock markets and strong investor rights are superior to all other systems. In contrast, the VOC literature argues that different combinations of institutions, via the complementarities they generate, produce similar economic outcomes and that no one single institutional setup is superior. In particular, the VOC literature allows for institutional setups dominated by strong and liquid market mechanisms and those characterised by complex networks to have similar levels of economic efficiency. 2. Critically review the La Porta et al. (1997, 1998) taxonomy of corporate governance systems in the light of recent corporate scandals and academic research. Recent corporate scandals have somewhat put in doubt the La Porta et al. taxonomy. Indeed, the latter argues that managerial excesses (such as excessive risk taking) are less likely to occur in common law countries where investor protection is supposed to be better than in civil law countries.

13 © Pearson Education Limited 2012

CHAPTER 5

Incentivising managers and disciplining of badly performing managers Discussion questions 1. Critically review the academic literature on the impact of managerial ownership on firm value. There are two types of studies on the link between managerial ownership and firm value. The earlier studies assume that the direction of causality flows from managerial ownership to firm value. In other words, these studies assume that managerial ownership is given, i.e. determined outside the system and is exogenous. Later studies question the direction of causality and allow for a reversal and/or a direction of causality that flows both ways. While the former studies find a link between the two, later studies do not find such a link. 2. ‘One way of achieving good corporate governance is to ensure the independence of non-executives sitting on the board of directors.’ (Anonymous) Discuss the above statement in the light of the empirical evidence on the impact of independent directors on firm performance. Very few studies on the link between non-executive directors and firm performance find any link whatsoever, questioning the effectiveness of non-executives as an efficient corporate governance device. However, the absence of such a link may be due to the possible endogeneity of the proportion/number of non-executives on the board of directors. For example, firms that are going through a period of bad performance may have been pressurised in appointing more non-executives to their board. At the same time, firms that have always performed relatively well may have done so because of the high proportion of non-executives on their boards and the monitoring of the executives performed by the non-executives. Still, despite the absence of clear evidence in favour of the effectiveness of non-executives, it is then somewhat surprising that countries such as the UK have put so much focus on the role of nonexecutives in corporate governance. 3. Contrast the advantages and disadvantages of single-tier boards with those of twotier boards. The main argument in favour of the single-tier board is improved information flows and communication between the executive directors and the non-executive directors as both types of directors sit on the same board. In turn, this should improve the monitoring of the executives by the non-executives. The main argument in favour of two separate boards is the independence of the non-executives vis-à-vis the executives. Advocates of the two-tier board argue that the independence of the non-executives will be compromised if both non-executives and executives sit on the same board. Interestingly, French companies that can choose between the UK/US-style single-tier board and the German-style two-tier board overwhelmingly go for the former.

14 © Pearson Education Limited 2012

Goergen, International Corporate Governance, 1st edition, Instructor’s Manual

4. ‘Hostile takeovers are an effective means of turning around failing companies.’ Discuss the above statement with reference to relevant empirical literature. Henry Manne’s thesis is that hostile takeovers target badly performing companies and therefore act as a disciplinary mechanism. Badly run firms see their stock price decline which then makes them an attractive target for hostile raiders intend on gaining control and firing the badly performing management as soon control has been obtained. They will then put in place a betterperforming management and then benefit from the increase in the share price once the firm has been turned around. However, empirical evidence by William Schwert on the USA and Julian Franks and Colin Mayer on the UK suggests that targets of hostile takeover do not perform worse than targets of friendly takeovers or firms that remain independent. Hence, the empirical evidence does not support the thesis that hostile-takeover targets are failing companies.

15 © Pearson Education Limited 2012

CHAPTER 6

Corporate governance, types of financial systems and economic growth Discussion questions 1. What institutional factors have been shown to drive economic growth? Investment has been found to increase with the strength of civic norms, trust and the level of incomes, but to decrease with the price of investment goods. Economic growth has been shown to be positively related to the strength of civic norms, the degree of protection of property rights and negatively related to the importance of family ties and hierarchical religions in a country. However, trust has a positive effect over and above the strength of property rights. One possible reason why trust has explanatory even when one adjusts for the strength of property rights is that it proxies for the degree of trust between citizens, whereas the strength of property rights proxies for the trust in government institutions. The positive effect of trust on economic growth and investment is higher in poorer countries where formal institutions and the quality of law are likely to be weaker suggesting that trust is a substitute for the latter two. However, horizontal associational activity does not seem to have an impact on economic growth and investment. This suggests that horizontal associational activity has both a positive effect – as argued by Robert Putnam – and a negative effect – as hypothesised by Mancur Olson – on economic growth and investment and that both effects cancel each other out. 2. If you were to be the economic advisor to a developing country, how would you advise that country to design its institutions in order to promote economic growth and investment? Legal reforms tend to take a long time. It may be quicker to undertake a reform of government institutions targeting corruption, bribery and improving law enforcement, thereby increasing confidence in government. Still, such reforms may also take time and frequently bad perceptions persist even after successful reforms. 3. How do you reconcile what you have learnt from this chapter with the various taxonomies reviewed in Chapter 4? The strength of property rights, including the strength of investor rights, has a positive effect on both economic growth and investment. This suggests that there is some validity to the La Porta et al. taxonomy, which is based on legal families and the quality of law. However, there is also evidence that trust has an effect on economic growth and investment over and above the strength of property rights and that the effect of trust is strongest in poorer countries that tend to have weak institutions. Hence, trust between citizens may act as a substitute for strong institutions and high-quality law in some countries. Hence, there seems to be some veracity as to the varieties of capitalism (VOC) literature which argues that countries with strong non-market mechanisms, such as complex and long-term networks, may do equally well in economic terms as countries with highly developed and highly flexible markets.

16 © Pearson Education Limited 2012

CHAPTER 7

Corporate governance regulation in an international context Discussion questions 1. ‘According to La Porta et al. (1998), both the UK and USA are English law countries using case law. However, the two countries’ approaches to corporate governance regulation could not be more different.’ (Anonymous) Critically discuss the above statement. The UK approach to corporate governance regulation is principles-based and uses codes of best practice (‘comply or explain’ approach), whereas the US approach is much more prescriptive (e.g., the Sarbanes–Oxley Act and the Dodd–Frank Act). Hence, to some extent, the US approach is much more in line to what one would expect from a civil law country (i.e. the heavy reliance on codes of law) than from a common law country. 2. ‘The main problem with corporate governance regulation and codes of best practice is that they are reactive. Each new wave of corporate scandals causes yet another regulatory reform and frequently politicians, as a result of public pressure, resort to knee-jerk reactions, producing new regulation that does not address the real causes of corporate failures. Hence, corporate governance will never improve and corporate scandals will never cease.’ (Anonymous) Discuss the above statement in the light of recent regulatory developments in the UK and/or the USA. There are different ways of answering this question. One way would consist of reviewing the empirical evidence on the costs and benefits of the Sarbanes–Oxley Act. Another possible way would be to focus on successive UK codes of corporate governance and the increasing emphasis on the role of non-executives. The increasing emphasis on the role of non-executives may be somewhat surprising in the light of the absence of a link between financial performance and the proportion of non-executives on the board of directors. 3. Discuss the pros and cons of policies of positive discrimination from the point of view of companies, focusing on the board of directors. There are two contrasting views in the academic literature as to the effect of positive discrimination, such as positive discrimination of women, on firm performance. According to the equality view, all humans are equal in terms of their skills and competencies. Hence from the point of view of the firm, the proportion of women and the proportion of ethnic minorities do not matter. In contrast, the diversity view claims that females and ethnic minorities have different types of skills, knowledge and experiences that complement those of white males that dominate corporate boards. In support of the diversity view, evidence points out that male hormones induce excessive risk-taking behaviour. In contrast, women tend to be more cautious and riskaverse. Hence, having a gender balance on the board may have positive effects in terms of risk management.

17 © Pearson Education Limited 2012

Goergen, International Corporate Governance, 1st edition, Instructor’s Manual

Finally, some have argued that the Norwegian approach of requiring a minimum percentage of women on corporate boards has led to the ‘golden skirts’ effect whereby the same few women, given the scarcity of suitable female candidates, dominate corporate boards and hence cause more negative effects, by creating busy directors and decreasing board independence, than positive ones.

18 © Pearson Education Limited 2012

PART III

Corporate Governance and Stakeholders

19 © Pearson Education Limited 2012

CHAPTER 8

Corporate social responsibility and socially responsible investment Discussion questions 1. ‘Advocates of CSR argue that firms should pursue the “triple bottom line”: not only profits, but also environmental protection and social justice. This notion, if taken seriously, is “incomprehensible”, says Ms Bernstein [the head of a South African think-tank called the Centre for Development and Enterprise]. Profits are easy to measure. The many and often conflicting demands of a local community are not. A business that is accountable to all is in effect accountable to no one, says Ms Bernstein.’ (The Economist, ‘Companies Aren’t Charities’, 23 October 2010, p.82). Discuss the above statement in the context of what you have learnt in this chapter. There is some degree of validity to Ms Bernstein’s statement as it may be difficult to satisfy the interests of multiple stakeholders. However, the empirical literature on CSR (see e.g. Hillman and Keim (2001)) also suggests that improving the firm’s relation with its immediate or primary stakeholders increases shareholder value. Hence, Ms Bernstein may be wrong when she claims that it does not make sense to listen to the local community. In contrast, the empirical evidence suggests that CSR that improves the firm’s relations with stakeholders other than the primary stakeholders reduces the firm’s performance. Hence, Ms Bernstein’s statements need to be qualified in the light of the existing empirical evidence. 2. ‘Corporate social responsibility is a waste of shareholders’ money and is just another way the classic agency problem between the managers and the shareholders manifests itself.’ Discuss the above statement based on academic evidence as to the effect of corporate social responsibility on firm value and performance. Studies such as Hillman and Keim (2001) have found that there are two types of CSR and that each has a different effect on firm value and performance. The first type is stakeholder management, i.e. the improvement of the firm’s relationship with its primary stakeholders, which has been shown to have a positive effect on firm value. The second type is social issue participation (SIP), which does not improve the firm’s relationships with its primary stakeholders and has a negative impact on firm performance. Hence, there may be a case for distinguishing between ‘good and bad’ CSR, at least as far as the firm’s shareholders are concerned. 3. ‘Corporate social responsibility (CSR) can only be afforded by companies with good financial performance. Hence, studies that investigate the link between financial performance and CSR need to rethink the direction of causality between the two.’ (Anonymous) Discuss the validity of the above statement by referring to the existing empirical literature. Waddock and Graves (1997) did exactly that, i.e. rethink the direction of causality between CSR and financial performance. They argue that the causality may flow both ways. First, CSR may be an integral part of good management and of maintaining a good relationship with the firm’s

20 © Pearson Education Limited 2012

Goergen, International Corporate Governance, 1st edition, Instructor’s Manual

stakeholders. Second, CSR may be a consequence of the free cash flow problem. Managers who have access to large amounts of excess cash may spend some of it on social causes. Waddock and Graves find evidence for both, i.e. CSR increases firm performance and that more profitable firms spend more money on CSR. Hence, there is some validity to the above statement. 4. What is the empirical evidence on the effects of corporate social responsibility (CSR) on firm performance? This question is somewhat similar to Question 2 above, but would also require a discussion of the earlier studies on the impact of CSR on performance which found somewhat mixed results. For example, Vance (1975) found a negative effect of CSR on performance, whereas Wokutch and Spencer (1987) and McGuire et al. (1988) found a positive effect. Finally, Alexander and Buchholz (1978) did not find any effect of CSR on firm performance. 5. Is there a price for socially responsible investment or do SRI funds outperform other funds? The evidence from the Renneboog et al. (2008) study suggests that while socially responsible investment funds underperform the stock market as a whole they do not underperform compared to conventional investment funds. It is recommended that students read through this paper and make a critical assessment of the robustness of its results. In particular, similar to other studies in the area this paper does not address the relative nature of social responsibility. For example, some religious funds may not be willing to invest in industries that are perfectly respectable and responsible to other funds and investors. 6. How do you feel about Primark’s reaction to the discovery that one of its suppliers was using child labour (see Box 8.2)? Do you think their justification to walk about from their supplier makes sense? What would you have done in this situation? There are arguments on both sides. On one hand, Primark’s decision of walking away from a supplier using child labour clearly signals that they do not tolerate unethical behaviour and that the penalty for breaking their policy is severe. On the other hand, by walking away from its supplier Primark may worsen the plight of the workers employed by its supplier and prevent the supplier from becoming more ethical itself.

21 © Pearson Education Limited 2012

CHAPTER 9

Debtholders Discussion questions 1. Review the theoretical and empirical literature on the advantages and disadvantages of close lender relationships. What, if anything, do you conclude? The theoretical models by Greenbaum et al. (1989) and Rajan (1992) suggest that there is likely to be a trade-off between the improved access to finance from close bank relationships and the potentially higher costs of financing caused by the bank’s monopolistic position. The fact that close bank relationships may cause both benefits and costs may explain why studies analysing the impact of bank involvement (via close relationships and bank ownership) on firm performance have found conflicting results. In addition, bank involvement may also prevent the firm from investing in certain high-risk, shareholder-value creating projects, given that banks tend to be more risk-averse than shareholders. Further, empirical research suggests that banks smooth interest rates over time charging young firms below-market interest rates and older firms above-market rates. 2. What evidence is there about the expropriation of debtholders by shareholders? There is evidence of debtholder expropriation around ownership changes such as leveraged buy-outs and purchases of blocks of shares by hedge funds. Both types of ownership changes typically result in an increase in debt. While the existing debt may be protected by covenants, these are frequently insufficient. The new debt may also be more senior than the existing debt and have a shorter maturity. In addition, bankruptcy proceedings do not always strictly adhere to the seniority of the various debt issues. Finally, ownership changes such as purchases of blocks by hedge funds also frequently result in a decrease in collateral via a decrease in the firm’s assets and cash reserves. Overall, the empirical evidence suggests that there is expropriation of the existing debtholders by the shareholders as there is a significant correlation between the decrease in the value of the existing debt and the premium earned by the existing shareholders on their shares.

22 © Pearson Education Limited 2012

CHAPTER 10

Employee rights and voice across corporate governance systems Discussion questions 1. ‘Employee rights and investor rights are a zero-sum game. You can only improve the rights of one of these social groups by weakening the rights of the other group.’ (Anonymous) Critically discuss the above statement by referring to the relevant academic literature on corporate governance and capitalist systems. The law and finance literature assumes that improving workers’ rights can only be done by reducing investors’ rights. In other words, improving workers’ rights does not have a positive impact on the firm’s profitability. Hence, improvements in workers’ rights will only increase the share of the firm’s profits that go to the workers, but not increase the firm’s overall profit. In contrast, the VOC literature assumes that there is not necessarily a zero-sum game between workers’ rights and investors’ rights. As a result and in contrast to the law and finance literature, the VOC literature predicts that corporate governance systems characterised by long-term, strong relationships between employers and employees may have similar economic performance to that of systems with frictionless markets, including highly flexible labour markets. 2. Discuss the limitations of the dichotomous version of the VOC literature when it comes to categorising labour markets, work practices and employee training across Europe. The dichotomous version of the VOC literature, which distinguishes between two polar systems of corporate governance, i.e. liberal market economies (LMEs) and coordinated market economies (CMEs), fails to account for the great diversity across CMEs. In particular, while the CMEs of Austria, Germany, Sweden and Switzerland have high job security, Denmark and Norway have both flexible labour markets and some degree of job security. As a result, the latter two countries are often referred to as flexicurity economies. Further, South European economies of Greece, Portugal and Spain have features of both CMEs and LMEs. In common with the LMEs, CMEs have highly competitive markets that compete on prices. However, ownership and control of corporations is highly concentrated and often in the hands of families. Hence, job security in large firms tends to be high but less so in small firms. Enforcement of employment law also tends to be weak. Finally, France and Italy are somewhat idiosyncratic with France having adopted some of the features of Anglo-American capitalism over recent years and Italy sticking out due to its Northern regions dominated by small firms using highly skilled workers. 3. Download the figures for the level of employment rights and social security used in the Botera et al. (2004) paper from Andrei Shleifer’s website (http://www.economics. harvard.edu/faculty/shleifer) for your country. How do you feel about the characterisation of your country by Botero et al., taking into account your country’s economic performance over the last few decades? Do you agree with their conclusions?

23 © Pearson Education Limited 2012

Goergen, International Corporate Governance, 1st edition, Instructor’s Manual

There are clearly some countries, such as the Nordic economies of Denmark, Norway and Sweden, which have experienced sound economic performance despite strong employment rights and high levels of social security. These are the so-called flexicurity economies that have managed to combine flexible labour markets with high levels of worker protection. The way this system works is that the government retrains workers from industries in decline and then channels them towards growing industries. 4. What, if anything, can we conclude about the effects of employee ownership and employee board representation on firm performance and productivity? What are the likely limitations of the existing studies in the field? How, if at all, can these limitations be addressed? Theory disagrees as to the effects of employee stock ownership on firm performance. Proponents of employee ownership such as Drucker (1978) and Aoki (1984) argue that employee ownership aligns the interests of the workers with those of the shareholders. In addition, as employees have better information on the firm’s operational side than other shareholders, they tend to be better monitors of the management. Hence, employee ownership is likely to mitigate the principal–agent problem. Opponents of employee ownership such as Jensen and Meckling (1979) argue that employee ownership results in employee entrenchment and therefore reduces firm performance. While theory disagrees as to the impact of employee stock ownership on firm performance, the empirical evidence is as yet inclusive. The main reason why the empirical literature fails to provide strong support for one of the two contrasting theories is that most of the literature focuses on US employee stock ownership plans (ESOPs) that generate tax benefits. In addition, ESOPs may be used as a defence mechanism against a hostile raider or to increase shareholder returns in a takeover contest. Hence, when studying the market reaction to the adoption of ESOPs, it is difficult to disentangle the effects of employee ownership from the other effects that may also influence firm value and performance. Similarly, studies on the effect of employee ownership on financial and accounting performance as well as productivity are inclusive. However, there is some evidence from a cross-country study by Blasi et al. (2010) that employee ownership has beneficial effects if it is part and parcel of wider human resource policies targeting at incentivising employees. Studies on the effects of the German Co-determination law, which prescribes employee representation on the board of directors, generally suggest negative effects on productivity and performance. However, there is no evidence that employee board representation increases wage costs. Finally, Fauver and Fuerst (2006), who take into account the firm’s industry, find a positive effect of workers’ representation on the board on performance in industries where coordination and information sharing are important. This result, however, only holds when employees are represented on the board by the firm’s workers rather than trade union officials.

24 © Pearson Education Limited 2012

CHAPTER 11

The role of gatekeepers in corporate governance Discussion questions 1. ‘Gatekeepers are the solution to the principal–agency problem. They provide the monitoring of corporate managers that shareholders are unlikely to provide.’ (Anonymous) Discuss the above statement. Gatekeepers are likely to play an important role, especially in companies with dispersed ownership and control where there is a lack of monitoring of the management and the principal– agent problem is likely to be severe. However, it is unlikely that gatekeepers will be the allsolution to the principal–agent problem as, in turn, they are agents to their principals. Hence, they may suffer from conflicts of interests just like the companies’ management they are supposed to monitor. In addition, gatekeepers may also suffer from capture, i.e. the company may have significant influence over its gatekeepers enabling it to force the latter to serve its own interests rather than preventing corporate malpractice and wrongdoing. 2. Provide examples of incentive problems and conflicts of interests that the various gatekeepers may suffer from. Corporate scandals such as Enron have highlighted the danger that auditors may suffer from conflicts of interests if they provide other, non-audit services (such as consulting) to their clients. In order to guarantee the provision of these non-audit services, auditors may be tempted to give their client company an easy ride when performing their audit of its accounts. Financial analysts were the other type of gatekeeper in the Enron scandal that failed to perform their role as monitors and gatekeepers. Rather than scrutinising Enron’s accounts and strategic decisions, they fuelled the rise in its stock price by issuing consecutive buy recommendations for the company’s stock. Similar to auditors, investment banks may also suffer from internal conflicts of interests. Such conflicts of interests are likely to exist between a bank’s underwriting department and its research department. In particular, the former may put pressure on the latter to issue strong buy recommendations to ensure future business from the issuing company. Lawyers dealing with corporations are of two types: in-house legal counsels and outside lawyers. While the latter typically only have limited information on the corporation, which limits their role as a gatekeeper, the former may be too closely connected to the corporation to act as an independent gatekeeper. Similar to auditors and lawyers, credit rating agencies are paid for by the company. As it is in the company’s interest to obtain the highest possible credit rating for its debt, it may shop around and then employ the services of the credit rating agency that is willing to offer the highest such rating. The lack of competition within the credit rating agency may also limit the negative effects of wrong credit rating decisions on the reputation of the agencies. Although the above gatekeepers are employed and paid for by the company they are assumed to monitor, corporate governance rating agencies do not suffer from this shortcoming as they are paid for by investors in need of corporate governance assessments for possible investee

25 © Pearson Education Limited 2012

Goergen, International Corporate Governance, 1st edition, Instructor’s Manual

companies. Hence, they do not suffer from conflicts of interests. However, they often tend to paint companies with the same brush, perpetuating a box-ticking approach to corporate governance, failing to take into account the particular conflicts of interests that may prevail in a company and the particular corporate governance devices that are needed to mitigate these conflicts. 3. What reasons have been advanced to explain the weak pay-performance sensitivity in regulated industries? Studies on managerial compensation in regulated industries have found that pay-performance sensitivity is lower compared to unregulated industries. In addition, studies focusing on the effects of deregulation have found that the pay-performance sensitivity increases after the deregulation. The reasons for the lower pay-performance sensitivity of managerial compensation in regulation industries are as follows. First, regulation reduces managerial discretion and reduces the set of managerial actions that increase firm value. Hence, regulation diminishes the returns to good management and the need for incentive-based managerial remuneration. Second, regulation may also have a more direct effect on managerial compensation and its sensitivity to performance via the political pressure on keeping salaries low to avoid public outrage about what may be perceived to be excessive levels of compensation.

PART IV

Improving Corporate Governance

CHAPTER 12

Corporate governance in emerging markets Discussion questions 1. Are stock markets and strong investor rights necessary and sufficient to ensure economic development? Academics are split as to the role of the role and importance of stock markets in economic development. On one hand, the law and finance literature argues that the existence of efficient market mechanisms, such as highly developed stock markets, is necessary and sufficient to ensure economic development. This literature argues that stock markets are best at allocating resources to the most productive firms within an economy. On the other hand, Franklin Allen and others question the infallibility of markets. In particular, markets fail to take account of negative externalities, i.e. costs imposed on others by one’s economic activity. Such negative externalities include environmental pollution. Allen also doubts that stock markets are capable of improving the equity of income distribution which is highly skewed in developing countries. Allen justifies his argument that stock markets and strong property rights are neither necessary nor sufficient for economic development via the examples of China and the UK during the first few decades of the 20th century. Both economies experienced rapid economic growth despite weak property rights and/or large stock markets. Ajit Singh advances two additional reasons with stock markets that may not necessarily be better at allocating economic resources than other, non-market-based mechanisms. First, stock markets may be subject to bubbles caused by overoptimism and the overvaluation of securities. During these bubbles, economic resources are likely to be directed to those companies that benefit from the overoptimism of investors, but that are not necessarily those that will make the most efficient use of the economic resources they are allocated. Second, there is evidence that the reallocation of economic resources via the market for corporate control, i.e. takeovers, is not efficient either. Indeed, contrary to expectations it is the larger, less-efficient firms that tend to initiate takeovers and target smaller, profitable firms. Hence, the market for corporate control tends to favour the survival of companies that are less efficient. A more balanced view is that, while stock markets may be neither necessary nor sufficient for economic development, they may nevertheless constitute a valuable source of finance for companies and their existence is likely to increase the sources of finance that companies can tap into. 2. What are the political, institutional and economic implications if wealth within a country is mostly inherited rather than created by entrepreneurs? Morck et al. (2000) find a negative correlation between inherited billionaire wealth and economic growth. They justify this pattern by four reasons. The first reason is an institutional one. Given that wealth is inherited from one generation by the next one, this is likely to cause managerial entrenchment and keep in place bad family managers. The second reason is an economic one and it concerns the unequal distribution of wealth, which is likely to create strong market power in the capital markets, reducing the efficiency of the latter. The third reason is an institutional one. Inherited wealth tends to be highly conservative, intend on enforcing the status quo rather than promoting technological innovation. The final reason is a political one. As inherited wealth frequently has very strong ties with the political classes, this further reinforces their entrenchment via the reduction of capital mobility and other barriers to trade.

Goergen, International Corporate Governance, 1st edition, Instructor’s Manual

3. Discuss the theory and evidence on the value of firms’ political connections. There are two theoretical views on the impact of political connections on shareholder value. These are the ‘grabbing hand’ of government and the ‘helping hand’. According to the first view, politicians sitting on the boards of directors of corporations pursue their own objectives, including their personal gain and winning favours for their electorate via creating new jobs and securing existing ones. Hence, even though politicians may create value, they are likely to appropriate most or all of this value creation. As a result, the overall effect from political connections is likely to be nil or even negative. According to the second view, political and government connections generate favours and privileges such as government subsidies, government procurement orders and protection from foreign competitors. The empirical evidence is somewhat mixed as to the effect of political connections on firm value. For example, Faccio (2006) finds that ties of firms with politicians prevail in countries perceived to be highly corrupt. She does not find any significant market reaction to the appointment of politicians to corporate boards. In contrast, Fisman (2001) and Johnson and Mitton (2003) find that political connections create significant value for the case of Indonesia and Malaysia, respectively. However, Faccio’s study suggests that it is also important to distinguish the type of political connection as this is likely to have a significant effect on whether there is value creation or not. Indeed, her study suggests that business people who become politicians create value via their political connections for their firms as reflected by a positive stock price reaction to their political appointment.

CHAPTER 13

Contractual corporate governance Discussion questions 1. How can firms located in countries with weak corporate governance standards credibly improve their corporate governance? There are three main ways whereby firms from countries with weak corporate governance standards can credibly improve their governance. The first way consists of being involved in a cross-border merger as a target or bidder. As a target, the firm would seek to be taken over by a bidder with better corporate governance and then benefit from the positive spillover effect. The latter relates to the improvement in the target’s corporate governance via the better corporate governance of the bidder. As a bidder, the firm would benefit from the bootstrapping effect that consists of improving its corporate governance via taking over a target with stronger corporate governance. However, this bootstrapping effect only seems to apply to partial acquisitions whereby the bidder becomes subject to the regulation of the target’s home country under the extraterritoriality principle. The second way consists of the firm reincorporating in a country (or state) with better investor protection. The third way consists of the firm cross-listing its shares on a stock market based in a country with stronger investor protection. 2. Critically review the evidence on the validity of the bonding hypothesis. Overall, there is strong evidence in the empirical literature that firms from countries with weak investor protection cross-list in markets with better and more stringent regulation to commit themselves not to expropriate their shareholders. 3. ‘Competition between national legislators and regulators should be avoided at all costs as it will result in a furious race to the bottom, dragging all concerned to the lowest common denominator.’ (Anonymous) Discuss the validity of the above statement. There are two schools of thought as to the effects of regulatory competition via reincorporations. The first school (see e.g. Cary (1974)) argues that regulatory competition is bad as it will lead to the bottom, as legislators will cater for managerial preferences rather than investors’ preferences. The second school (see e.g. Winter (1977)) argues that competition between legislators is healthy and will lead to a race to the top. The empirical evidence does not as yet give overwhelming support for one of these schools of thought.

CHAPTER 14

Corporate governance in initial public offerings Discussion questions 1. Discuss the use of IPO underpricing by CEOs and VCs in the pursuit of their own interests. There is evidence from a UK study by Brennan and Franks (1997) that insiders, including the CEO, deliberately underprice their firm’s shares at the time of the IPO to cause oversubscription of the issue, which, in turn, enables them to discriminate against large applicants and to keep outside ownership concentration to a minimum. In contrast, VCs may not be aiming for underpricing, but may cause (higher) underpricing by grandstanding and taking their investee firms public early to enhance their reputation. In other words, young VCs may find it difficult to raise additional funds unless they have a track record of investee firms that have made it to the stock market. By rushing their investee firms to the stock market, the VCs cause higher underpricing as empirical studies have shown that there is an inverse link between the level of underpricing and firm age. While the benefits from the early underpricing, via the enhancement in their reputation, are entirely incurred by the VCs, the costs from doing so, via the higher underpricing are borne by all the pre-IPO shareholders. 2. Review the various dimensions of CEO power. Finkelstein (1992) proposes four dimensions of the power of top management, including the CEO. The first dimension is structural power. Structural power is derived from the CEO’s position within the firm’s organisational and hierarchical structure. It may also be enhanced by the superior information the CEO may have about the firm compared to others. Structural power helps the CEO push through decisions that may not have the approval of the other top managers. The second dimension is ownership power. Ownership power stems from the CEO’s ownership stake in the firm and is likely to increase in line with the size of the latter. Ownership power is also higher for CEOs who are the founders or are related to the founders. The third dimension of CEO power is expert power. CEOs have expert power over their firm via their specialist knowledge, such as their knowledge about technologies that the firm uses. His/her expert power may make the CEO indispensable to the firm and entrench the CEO. The fourth dimension of CEO power is prestige power. A CEO derives prestige power from his/her standing and reputation within the larger business community. The behaviour and decisions of CEOs with great prestige power are likely to be copied by CEOs with less prestige power, further enhancing the power and status of the former. Chahine and Goergen (2011) propose a fifth dimension of CEO power which is control power. Control power measures how pivotal the CEO is in the voted decision. Control power depends not only on the CEO’s ownership stake (as ownership power does) but also on the ownership stakes of all the other shareholders.

Goergen, International Corporate Governance, 1st edition, Instructor’s Manual

3. Discuss the practice of ‘spinning’ IPOs. In the recent past, some investment banks have been found to ‘spin’ IPOs, by using the underpriced shares as bribes and allocating them to their clients to generate further fee-earning business from them in the future. The underpriced shares were also allocated to the executives of the underpriced IPO firms to ensure their loyalty. Xiaoding Liu and Jay Ritter found that US IPOs whose executives had been spun were more underpriced than other IPOs and were less likely to switch investment banks in the future. 4. What is the role of VCs in the design of IPO firms’ corporate governance? Apart from providing finance, VCs are also frequently instrumental in the design of the organisational structure of IPO firms, setting up the top management team and attracting other key employees, providing networking for the creation of strategic alliances and helping the firms establish their market share. VCs are also frequently behind the replacement of the founder CEO by a professional manager. While the founder CEO is likely to resist his replacement, VCs often succeed in appointing a new CEO due to the votes and the board seats they hold. VCs also frequently have agreements with the CEO that enable them to terminate his/her employment and ownership if certain milestones are not achieved. Finally, the founder CEO’s shares are often vested shares, i.e. the shares are held by the firm on his/her behalf and ownership of the shares is only transferred to him/her once certain milestones have been achieved. 5. Explain the possible conflict of interests certain VCs may suffer from. Young VCs may take their investee firms public early, at the cost of higher underpricing, to build up a reputation as a successful VC. While the benefits from doing so accrue to the VC, the cost of the higher underpricing is borne by all the pre-IPO shareholders. This conflict of interests was highlighted by Gompers (1996) and is referred to as grandstanding. VCs need to build up a reputation to ensure access to funds in the future, given their organisational structure. Indeed, most VC firms are in the form of partnerships with the silent partners, typically institutional investors, providing all the funding. The silent partners will only be willing to provide further funding if there have been successful exits from firm via a flotation on the stock exchange.

CHAPTER 15

Behavioural biases and corporate governance Discussion questions 1. In 1984, the magazine The Economist asked 4 ex-finance ministers of OECD countries, 4 chairmen of multinationals, 4 Oxford University economics students and 4 dustbin men to predict several economic factors for the OECD 10 years ahead. The factors to be predicted included the average growth rate, the average inflation, the price of petrol in 1994, and when Singapore’s GDP would exceed that of Australia. In 1994, the magazine revisited the predictions of each of the above 4 groups and checked their accuracy against the actual numbers. The winners were jointly the businessmen and the dustbin men, followed by the students and the last were the exfinance ministers. What behavioural bias does the result from this experiment illustrate? The likely behavioural bias is overconfidence by the experts. Experiments suggest that experts are more likely to suffer from overconfidence relative to other people if the task at hand is highly complex. 2. How can boardrooms be turned into forums for constructively discussing and challenging the CEO’s proposed strategic choices rather than places that just rubberstamp the latter? In order to avoid the rubber stamping of the CEO’s proposed decisions, boards of directors need to be designed in ways that there is enough scrutiny of the way the CEO runs the firm during the and boardroom meetings. Given that Morck (2008) argues that members of the board of directors have an innate tendency of being loyal to the CEO, it is important to reduce the dominance of the CEO at the boardroom meetings. While US and UK regulators have attempted to do so by emphasising the role of non-executive directors as well as their independence vis-à-vis the CEO, there is however little evidence of an impact of board independence on firm value. In addition, the Higgs Report in the UK recommends that the CEO should not share the boardroom meetings. This recommendation makes sense in the light of the behavioural bias of large framing or packing. There is a large framing effect if the way information is presented and packaged influences the decision taken. Preventing the CEO from chairing the boardroom meetings may prevent such effects as the way the information is presented to the members of the board of directors is likely to be more objective. However, there are also potential costs from having an outsider chairing the meetings. Such costs include more cumbersome decision making, including longer response times. 3. ‘Misplaced loyalty lies at the heart of virtually every recent scandal in corporate governance.’ (Morck 2008, p.180) Discuss the above statement with particular relevance to the arguments advanced by Morck (2008). On the basis of the evidence on humans’ reflexive loyalty to superiors obtained from the experiments conducted by the psychologist Stanley Milgram, Morck (2008) argues that there is need for revisiting the principal–agency theory. He argues that there are two rather than just one principal–agent problem. The type I agency problem is the classical agency problem between the managers and the shareholders. At the source of this problem is the lack of loyalty of the

Goergen, International Corporate Governance, 1st edition, Instructor’s Manual

management to the shareholders. In contrast, the new type of agency problem, type II, is caused by excessive loyalty, in particular the excessive loyalty of the board members to the CEO, rather than a lack of loyalty. There is evidence from recent corporate scandals, such as Enron, Worldcom and Hollinger, that powerful CEOs may dominate boardroom meetings and their decisions, even those that threaten the survival of the firm, may be left unchallenged.

Exercises N.B. It makes sense to do these exercises with a large class of students during the actual lecture, record the answers and then discuss the possible biases observed. 1. You are forced to enter the following gamble which is characterised as follows. There is: •

a 75% chance of losing £7,600

•

and a 25% chance of winning £2,400.

You are now offered £100 upfront before you are told the outcome of the gamble. If you accept the £100, your total payoff after the gamble will be: •

a 75% chance of losing £7,500

•

and a 25% chance of winning £2,500

a) Does it make sense to accept the £100? Yes, it does, as your payoff will always be higher by £100. In detail, without the £100 your expected payoff from the gamble will be 0.75 * (−7,600) + 0.25 * 2,400 = −£5,100, whereas if you accept the £100, the payoff will be −£5,000. b) You now face the two concurrent decision problems. You need to choose between A and B as well as between C and D. Option A consists of a sure gain of £2,400 and option B is gamble characterised by a 25% change of winning £10,000 and a 75% chance of winning nothing. So, choose between A and B. Option C is a sure loss of £7,500 and option D consists of a gamble characterised by a 75% change of losing £10,000 and a 25% chance of losing nothing. Choose between C and D. If this experiment is repeated with a large number of subjects, the most popular answer tends to be A and D. Alternative A is the risk-averse choice compared to alternative B which is risky. While the expected payoff from B is £2,500, i.e. £100 higher than the payoff from A, most people prefer the lower, but risk-free payoff from A. This may still be perfectly rational. However, in relation to the second decision problem most people tend to opt for the opposite strategy, i.e. they prefer alternative D to alternative C. Similar to A, C is the risk-averse choice. In other words, the payoff from C is always −£7,500. Although there is a 75% chance from D of making a much heavier loss of £10,000, most people focus on the fact that D offers a 25% chance of losing nothing. In fact, the expected payoff from D is also −£7,500. However, contrary to C, D is the risky choice. Hence, most people are willing to gamble when facing a loss, but not when facing a possible gain, and this despite the fact that in this example there is a £100 incentive to gamble with the gain. This example illustrates two behavioural biases in human behaviour. The first one is mental accounting, i.e. people treat losses differently from gains. The second one is loss aversion. Most humans will do anything to avoid the hurtful experience of a loss. Hence, most people confronted with the above decision problems will prefer D to C.

Goergen, International Corporate Governance, 1st edition, Instructor’s Manual

So what is the optimal choice? The optimal choice is B and C as this choice has the highest possible payoff, i.e. −£5,000 ((−7,500 + 0)*0.75 + (−7,500 + 10,000)*0.25), whereas the payoff from A and D is only −£5,100 ((2,400 − 10,000)*0.75 + (2,400 + 0)*0.25). In fact, choice B and C always generates £100 more than choice A and D. In detail, B and C give a 75% chance of a loss of £7,500 and a 25% chance of a gain of £2,500. A and D give a 75% chance of a loss of £7,600 and a 25% chance of a gain of only £2,400. In other words, the choice between B + C and A + D is the same as the choice offered under part (a), i.e. the accepting or rejecting the £100 paid upfront. Hence, this example also illustrates large framing or packaging effects. While both the decision problems under (a) and (b) have the same probability distribution, the decision problem under (a) is presented in a transparent and easyto-understand way, whereas the decision problem under (b) is presented in an opaque and cognitively costly way. By packaging the information in a different way, this extreme example shows that one can induce decision makers to take exactly the opposite decision. 2. Imagine 100 bags. The bags are opaque and there is no way of determining the exact content of each bag without turning the bag upside down and shaking out its content. Each bag contains 1,000 tokens. Forty-five of the bags contain 700 black and 300 red tokens, i.e. a majority of black tokens. The remaining 55 bags contain 300 black and 700 red tokens, i.e. a majority of read tokens. One bag is selected at random. N.B. While this exercise seems to imply a focus on probability calculus, this is not the intended focus. What is important here is to illustrate the bias of conservatism rather than testing students’ understanding of probability calculus. Hence, this exercise can also be given to a class with little understanding of probability calculus. a) What is the probability that this bag contains mostly black tokens? The answer is 45% as there are 45 bags out of a total of 100 bags with mostly black tokens. b) Twelve tokens are drawn from this bag, with replacement. This means that, after a token has been drawn and its colour has been recorded, it is placed back in the bag. As a result, there are always 1,000 tokens in the bag before each draw. The result of the 12 draws is 8 black tokens and 4 red tokens. Based on this new information, what is the probability that this randomly selected bag is one of the bags with mostly black tokens? If this experiment is played with a large number of subjects, the most popular answers tend to be 45% and 66%. Those that answer 45% are very conservative, stick to their answer under part (a) and ignore the new information. Those that answer 66% concentrate on the fact that 8 of the 12 tokens, i.e. two thirds, that have been drawn, are black. However, both answers illustrate a high degree of conservativeness. Using Bayes’ theorem, the answer to this problem set is 96.04%. Hence, there is almost perfect certainty that the selected bag contains mostly black tokens. For information only (this does not form part of the actual answer), according to Bayes’ theorem:

Goergen, International Corporate Governance, 1st edition, Instructor’s Manual

P(Mostly blacks ¦ 8 blacks and 4 reds) =

P(8 blacks and 4 reds ¦ mostly blacks)  P(mostly blacks) P(8 blacks and 4 reds) 8

 7   3      0.45  10   10  8

 7   3  3  7       0.45 +      0.55  10   10   10   10  4

 7     0.45  10  4

 7   3    0.45 +    0.55  10   10 

= 0.9604 = 96.04% 3. There are four cards in front of you:

Please test the following hypothesis ‘All cards with a vowel on one side have an even number on the other side’ by turning over the card(s) and only those that will determine its validity. Most people turn over card A and some also turn over card 2. However, the correct answer is to turn over cards A and 3 only. The optimal way to test the hypothesis is to turn over only the cards that may falsify the hypothesis. Let us look at the falsification potential of each card. If we turn over card A, it may reveal an even or odd number. If the number is even this supports the hypothesis. Conversely, an odd number would falsify the hypothesis. Card B does not tell us anything about the validity of the hypothesis. By turning over card 2, we may see a vowel and this would support the hypothesis. Alternatively, we may uncover a consonant, which would neither support nor reject the hypothesis. Hence, this card has no falsification potential. Finally, there is card 3. If we uncover a vowel on that card, then the hypothesis is false. A consonant, however, provides no useful information. Hence, the only useful cards to turn over are A and 3. So why do most people turn over A and 2? The rule of thumb or heuristic they employ looks for confirmation of the hypothesis. So, they tend to put too much weight on evidence that confirms their beliefs and too little on evidence that contradicts their beliefs. In other words, they suffer from confirmatory bias.