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Agency Problems at Dual-Class Companies

By Harvard Law School Program on Corporate Governance

(Editor?s Note: This post comes from Ronald Masulis at the Owen Graduate School of Management, Vanderbilt University, Cong Wang at the Faculty of Business Administration, Chinese University of Hong Kong, and Fei Xie at the School of Management, George Mason University.)

In our paper Agency Problems at Dual-Class Companies, which was recently accepted for publication in the Journal of Finance, we use a sample of U.S. dual-class companies over the period 1994-2002 to examine how the divergence between insider voting rights and cash-flow rights affects managerial extraction of private benefits of control. Using both a ratio and a wedge measure to capture the voting-cash flow rights divergence, we find four distinctive sets of evidence supporting the hypothesis that managers with greater control rights in excess of cash-flow rights are more likely to pursue private benefits at the expense of outside shareholders.

First, we examine how control-cash flow rights divergence impacts a firm?s efficiency in utilizing an important corporate resource - cash reserves. We find that the marginal value of cash is decreasing in the divergence between insider voting rights and cash-flow rights, which is consistent with the argument that shareholders anticipate that corporate cash holdings are more likely to be misused at companies where insider voting rights are disproportionately greater than cash-flow rights, and therefore place a lower value on these highly fungible corporate assets.

Second, we analyze how the insider control-cash flow rights divergence affects the level of CEO compensation, and find that, ceteris paribus, excess CEO pay is significantly higher at companies with a wider divergence between insider voting and cash-flow rights.

Third, we evaluate the acquisition decisions made by dual-class companies, and find in a multivariate regression framework that as insider control-cash flow rights divergence widens, acquiring companies experience lower announcement-period abnormal stock returns, are more likely to experience negative announcement-period abnormal stock returns, and are less likely to withdraw acquisitions that the stock market perceives as shareholder value destroying. These results suggest that as insiders control more voting rights relative to cash-flow rights, they are more likely to make shareholder value-destroying acquisitions that benefit themselves.

Finally, we examine firms? capital expenditure decisions as another channel of empire building and private benefits extraction. We find that ceteris paribus, capital expenditures contribute significantly less to shareholder value at firms with a greater divergence between insider voting rights and cash flow rights, suggesting that managers at these companies are more likely to make large capital investments to advance their own interests.

Overall, our results shed direct light on the issue of how insider control-cash flow rights divergence leads to lower shareholder value. In addition, our results further our understanding of why superior-voting shares command a premium in the marketplace over inferior-voting shares.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on December 29, 2008 (boomark / email).