D18 Monitoring

Question 1

Monitoring: Basic idea

Answer 1

Reducing information asymmetries by „hiring monitors”
Monitoring is performed by external parties (boards of directors, auditors, large shareholders, large creditors, investment banks, rating agencies)

Question 2

Two types of monitoring

Answer 2

Question 3

Active monitoring (4 bullet points)

Answer 3

• Interfering with management in order to increase the value of the investor’s claims (use of control rights)
• collect information about firm policies and intervene to prevent value decreasing policies
• forward looking
• intervention depends on the identity of the monitor (large shareholder, raider, creditor)

Question 4

Monitoring by Board of Directors (BoD)

Answer 4

• define or approve major business decisions and corporate strategy (M&A, tender orders)
• executive compensation
• oversight of risk management
• audits

Question 5

3 Types of directors

Answer 5

(1) Inside directors: members of a board who are (former) employees or family members of employees
(2) Grey directors: members of BoD who are not as directly connected to the firm as insiders, but have existing or potential business realtionships with the firm
(3) Outside (independent) directors: any member of BoD other than inside or grey directors

Question 6

BoD: watchdogs or lapdogs?

Answer 6

(1) lack of independence
(2) insufficient attention
(3) insufficient incentives
(4) avoidance of conflict
- > Boards do interfere in some decisions, in particular during a crisis

Question 7

Investor activism

Answer 7

• *Active monitors** intervene in:
  (1) strategic decisions
  (2) investments
  (3) asset sales
  (4) managerial compensation
  (5) design of takeover defenses
  (6) board size and composition
• *control required**: formal control of a large owner, real control by a minority owner

Question 8

QQ: Basic model investor activism

Answer 8

auf DIN A4

Question 9

Hedge fund activism and firm performance

Answer 9

Activist hedge fund: propose strategic, operational, and financial remedies
attain (partial) success in 2/3 of cases
abnormal return around the announcement of activism is ∼7%
increases in payout, operating performance and higher CEO turnover after activism

Question 10

Limits of active monitoring (5 bullet points)

Answer 10

• who monitors the monitor?
• congruance with investors: undermonitoring, collusion with management, self-dealing
• costs of providing proper incentives to the monitor
• perverse effects on the monitorees
• legal, fiscal and regulatory obstacles

Question 11

Passive monitors

Answer 11

• Debt claim*: bank, commercial paper market, interbank market
• Equity claim*: speculators (analysts), derivative suits
• Equity-like claims*: credit enhancer, underwriter (firm commitment contract)
• Other claims*: rating agency, underwriter (best-efforts contract)

Question 12

Passive monitoring (5 bullet points)

Answer 12

• not linked to the exercise of control rights
  backward looking: measures current value
  information is used to adjust the monitors position in the firm (invest further, stay put, disengage)
  monitors: e.g. stock market analyst, short-term creditors

Question 13

How does passive monitoring reduce agency problems?

Answer 13

Passive monitoring makes the firm’s stock value informative about past performance
=> used directly to reward management or to force boards to pressure management: management discipline
Monitoring by short-term creditors drains liquidity from poorly performing firms

Question 14

Governance debate Anglo-Saxon vs Germany-Japan

Answer 14

Anglo-Saxon:
- well-developed stock markets, strong investor protection, disclosure requirements, shareholder activism, proxy fights, takeovers
Criticism: short-termism
Germany-Japan: important role relationship bank, private firms and a thin stock market, concentrated ownership, limited managerial contests
Criticism: collusive, favoring entrenched manager