External Corporate Governance Mechanisms

The legal or regulatory environment of a company, implying both laws and their enforcement, can be regarded as another basic element of corporate govern-ance.¹⁶⁷

One major reason for the willingness of investors to finance companies in the first place is that their rights and powers are protected by law.¹⁶⁸ However, a differentiated view has to be applied to providers of equity capital and those of debt capital. Shareholders are generally more exposed to opportunistic behav-ior by managers than debt holders since their rights are less precisely specified in contracts¹⁶⁹ and contractual violations are more difficult to verify by courts or other regulatory institutions¹⁷⁰. There is a wide range of legal rules that particu-larly help to protect shareholders against expropriation by managers or that permit shareholders to monitor managers more cheaply and effectively. These include e.g. voting right rules, disclosure rules, anti-fraud rules and insider-trading rules.¹⁷¹

The quality of legal protection can vary decisively across different countries and jurisdictions. Typically, as the extent and quality of protective rules as well as the efficiency of law enforcement increases, capital market participants tend to have a higher motivation to finance companies. Empirical support for this ar-gument comes from La Porta et al. (1997) who provide strong evidence that the development of capital markets is affected by the respective legal environment.

Thereafter, legal regimes with high levels of investor protection and great effi-ciency of legal enforcement are associated with larger and broader capital mar-kets, indicating a greater willingness to provide companies with capital.

167 See La Porta et al. (1997), p. 1131; La Porta et al. (2000), p. 4; Daines (2001), p. 525f;

Lombardo/Pagano (2002), p. 1; Bruno/Claessens (2006), p. 1.

168 See Shleifer/Vishny (1997), p. 752; La Porta et al. (2000), p. 4.

169 See Lombardo/Pagano (2002), p. 1; Schillhofer (2003), p. 39.

170 See Shleifer/Vishny (1997), p. 752.

171 See also Nowak (1997), p. 49; La Porta et al. (1998), pp. 1122f; La Porta et al. (2000), pp.

6f.

Consistent with the notion that better legal protection mitigates agency prob-lems, Klapper/Love (2004) show that companies from countries with weak legal environments have on average lower corporate governance rankings. Further-more, Daines (2001) and La Porta et al. (2002) find a significantly positive as-sociation between the quality of laws protecting shareholders and market valua-tion. Similarly, Lombardo/Pagano (2002) document that the respect for legal rules and judicial efficiency are significantly positive correlated with the risk-adjusted return on equity.

Even though playing a role in corporate governance, legal protection is lim-ited to a certain extent by virtue of the design of legal systems and the difficulty to verify all types of opportunistic behavior of managers. Hence, it appears to merely constitute a basic component in a corporate governance system that needs to be complemented by other disciplining mechanisms.

2.2.4.2 Market for Corporate Control

There is a wide-spread belief among academics that capital markets perform a monitoring and disciplining function through what is generally referred to as the market for corporate control.¹⁷² Traditionally, the market for corporate control is represented by financiers who try to get control over a company to replace in-cumbent management and to improve resource allocation.¹⁷³ Thereby, corpo-rate resources are redistributed from poor or underperforming to good or out-performing management teams.¹⁷⁴

One important premise in connection with the market for corporate control is that the efficiency of management is correctly reflected in current share prices.

As the share price deteriorates following poor managerial performance a com-pany is likely to become a hostile takeover target.¹⁷⁵ Other market participants

172 See Manne (1965), p. 112; Winter (1977), p. 289; Jensen/Ruback (1983), p. 6; Jensen (1988), p. 23; Holmström/Tirole (1993), pp. 678f; Stapledon (1996), p. 11.

173 In contrast, Jensen/Ruback (1983), p. 6, regard the market for corporate control as “a market in which alternative managerial teams compete for the rights to manage corporate re-sources”.

174 See Stapledon (1996), p. 11.

175 See Manne (1965), p. 112; Scharfstein (1988), p. 186.

may sooner or later identify that the company is undervalued. Consequently, they will try to take over the company, typically by making a tender offer to mi-nority shareholders, in order to replace management¹⁷⁶ and to capture the as-sociated gain in value.

Consistent with this intuition, Morck et al. (1988b) find that predominantly poorly performing companies tend to be targeted for takeovers. In turn, Jen-sen/Ruback (1983) show that target firms experience significantly positive ab-normal returns between 20% and 30% right after a takeover transaction has been executed. Furthermore, Martin/McConnell (1991) document a significantly positive turnover rate for top managers of poorly performing companies after a successful completion of tender offer takeovers. Thus, it can be presumed that hostile takeovers as well as the threat of such takeovers and the inherent threat of being fired motivate managers to run the company in the interests of share-holders.¹⁷⁷

Nonetheless, some researchers cast doubts on the effectiveness of corpo-rate takeovers as a governance mechanism. Shleifer/Vishny (1988, 1997), for instance, argue that takeovers are so expensive that they only address major agency problems. Moreover, Shleifer/Vishny (1988) highlight that takeovers can also be associated with increased agency costs when the acquiring party over-pays in the acquisition process. In contrast, Stein (1988) suggests that takeover pressure can have undesirable effects to the extent that managers sacrifice long-term shareholder interests by boosting short-term earnings in order to keep up current stock prices and to prevent potential takeover attempts. A simi-lar line of argumentation is provided by Easterbrook/Fischel (1981) and Morck

176 See Winter (1977), p. 289; Shleifer/Vishny (1988), p. 11; Shleifer/Vishny (1997), p. 756.

177 See Manne (1965), p. 113; Grossman/Hart (1982), p. 107, Jensen/Ruback (1983), pp. 29f;

Morck et al. (1988b), p. 103; Scharfstein (1988), p. 185; Holmström/Tirole (1993), p. 679;

Stapledon (1996), p. 11; Ghosh/Sirmans (2003), p. 291; Cremers/Nair (2005), p. 2864. Ac-cording to Stapledon (1996), p. 11, equity as well as debt issuances can be considered as a second disciplining mechanism in the context of the market for corporate control. If a com-pany is inefficiently managed and performs poorly it will be difficult to raise capital on equity as well as on debt capital markets. Equity placements may only be possible at substantial discounts whereas debt capital will only be granted at higher interest rates, ultimately raising a company’s cost of capital. This, however, has a significantly negative impact on the firm’s competitive position, implying a greater risk of going out of business. Therefore, managers should be interested to avoid any sort of mismanagement or reduced effort.

et al. (1988b), among others, who indicate that managers may resist corporate takeovers by applying diverse defensive tactics.

In summary, the market for corporate control appears to be a governance mechanism that serves as a last resort after other, predominantly internal mechanisms have failed to react.

2.2.4.3 Market Competition

Apart from a country’s legal or regulatory environment and the market for corpo-rate control, competitive forces in product and managerial labor markets may serve as external mechanisms of corporate control. The basic notion is similar to the one of neo-classical economics which claims that the market takes care of all inefficiencies.¹⁷⁸

Such inefficiencies may include costs resulting from mismanagement or managerial diversion of corporate resources which are eventually reflected in a company’s product prices. As pointed out by Jensen (1986), competition in product markets leads to a price-equilibrium with a minimum average cost of activity. It can be argued that this necessarily increases pressure on manage-ment to enhance efficiency of resource allocation and, hence, to cost-efficiently run their companies in order to stay competitive and to survive in the market.¹⁷⁹ Managers may be particularly interested to avoid losing competitiveness and possibly going into bankruptcy due to the loss of benefits associated with their position¹⁸⁰ and potential reputation costs that would worsen their chances for attractive future employment opportunities.

Moreover, managers find themselves in a situation of competition with other executives from inside and outside the firm. In this context, they may not only be interested to avoid bad news in connection with their person but to perform

178 Alchian (1950) and Stigler (1958) have expressed the view that managerial discretion cannot survive in competitive markets. This intuition has been empirically supported by Giroud/Mueller (2007).

179 See Hart (1983), p. 366; Jensen (1986), p. 323; Baily/Gersbach (1995), p. 308; Sirmans (1999), p. 2; Börsch-Supan/Köke (2002), p. 312.

180 See Grossman/Hart (1982), pp. 108, 131.

exceptionally well for reasons of internal promotion and external advance-ment.¹⁸¹

Given the assumption that managerial labor markets are highly competitive and adequately assess the managerial talents¹⁸², executives are only able to guard their positions if they are successful in what they are supposed to do:

create and maximize long-term shareholder value. Otherwise, they will get re-placed by other managers who are at least as well qualified and who are more committed to the job.

However, it is often questioned how efficient those market mechanisms ac-tually work.¹⁸³ Jensen (1993) and Schillhofer (2003), for instance, allude that product and factor markets do not instantaneously perform their control function but start to react only after a certain time-lag.¹⁸⁴ Furthermore, it can be asserted that the market mechanism in managerial labor markets does only work well in business sectors with a great pool of skilled and qualified executives. If there is only a limited number of individuals with the necessary skills and experiences to run a particular company, managers are obviously less pressured, for they are aware of their significance for the company.

For reasons of market inefficiencies, one can conclude that market competi-tion, similarly to the market for corporate control, does only serve as a potential secondary control mechanism that may come into effect after other governance mechanisms have failed.

181 See Alchian/Demsetz (1972), p. 788; Stapledon (1996), p. 11; Ghosh/Sirmans (2003), p.

291.

182 See Fama (1980), p. 292.

183 See for instance Demsetz/Lehn (1985), p. 1159; Stapledon (1996), pp. 15f.

184 See Jensen (1993), p. 850; Schillhofer (2003), p. 43.

2.3 Listed Property Vehicles

To get an idea of the companies being examined in the course of this disserta-tion, the two following chapters shall define the two principal types of listed property vehicles. These include publicly traded real estate companies as a more general form and real estate investment trusts (REITs) as a more specific form of listed property vehicles.