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able of contents

1. Corporate capital structure in the United kingdom: determinants and adjustment....................................... 1

2. Agency problems and debt financing: leadership structure effects.............................................................. 2

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evidence of adjustment in dividends and new equity issuance, with the proviso that investment appears to bemore responsive to a flow measure of financial pressure than a stock measure of balance sheet disequilibrium.Illustrative simulations show how firms may adjust their balance sheets in response to shocks that move gearingfurther away from its implied equilibrium. Although firms appear to respond quickly and make relatively largeadjustments to the flows, the actual adjustment process is likely to be protracted because the flows of dividends,equity issuance and investment are all small in relation to the stock of debt.

Subject Balance sheets; Corporate finance; Debt management; Studies;

Location United Kingdom, UK Classification 3100: Capital & debt management; 9175: Western Europe; 9130: Experimental/theoretical Publication title Bank of England. Quarterly Bulletin Volume 44 Issue 3 Pages 327 Number of pages 1 Publication year 2004 Publication date Autumn 2004 Year 2004 Publisher Bank of England. Economics Division. Bulletin Group Place of publication London Country of publication United Kingdom

Publication subject Business And Economics--Banking And Finance, Business And Economics--EconomicSituation And Conditions ISSN 00055166 CODEN BEQBDP Source type Scholarly Journals Language of publication English Document type Feature ProQuest document ID 215016691 Document URL http://search.proquest.com/docview/215016691?accountid=27544 Copyright Copyright Bank of England. Economics Division. Bulletin Group Autumn 2004 Last updated 2010-06-08 Database ABI/INFORM Complete _______________________________________________________________ Document 2 of 2

Agency problems and debt financing leadership structure effects

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Author Fosberg, Richard H Publication info Corporate Governance 4.1 (2004): 31+.ProQuest document link Abstract In previous research, Friend and Hasbrouck theorized that managerial insiders (officers and directors)have a personal incentive to cause the firm to use less than the optimal amount of debt in its capital structure.

They suggested this occurs because officers and directors have a large proportion of their personal wealthinvested in the firm in the form of common stock holdings and firm-specific human capital. This makesmanagerial insiders reluctant to use the optimal amount of debt financing for the firm because of the additionalbankruptcy risk higher levels of debt engender. I test FH's theory and find evidence that supports it. Specifically,the amount of debt in our sample firms' capital structures declines as the percentage of the firm's common stockheld by the CEO and other officers and directors increases. A direct relationship is found between blockholder share ownership and our sample firms' debt/equity ratio. This suggests that monitoring by blockholders iseffective in controlling the suboptimal debt usage agency problem. Further, for any given level of blockholder share ownership, the greater the number of blockholders a firm has the less effective blockholders are in raising

the amount of debt in the firm's capital structure. Lastly, some weak evidence was found suggesting that a dualleadership structure was effective in increasing the amount of debt in a firm's capital structure. [PUBLICATION

ABSTRACT]

Full text Headnote

Abstract In previous research, Friend and Hasbrouck theorized that managerial insiders (officers and directors)have a personal incentive to cause the firm to use less than the optimal amount of debt in its capital structure.They suggested this occurs because officers and directors have a large proportion of their personal wealthinvested in the firm in the form of common stock holdings and firm-specific human capital. This makesmanagerial insiders reluctant to use the optimal amount of debt financing for the firm because of the additional

bankruptcy risk higher levels of debt engender. I test FH's theory and find evidence that supports it. Specifically,the amount of debt in our sample firms' capital structures declines as the percentage of the firm's common stockheld by the CEO and other officers and directors increases. A direct relationship is found between blockholder share ownership and our sample firms' debt/equity ratio. This suggests that monitoring by blockholders iseffective in controlling the suboptimal debt usage agency problem. Further, for any given level of blockholder share ownership, the greater the number of blockholders a firm has the less effective blockholders are in raisingthe amount of debt in the firm's capital structure. Lastly, some weak evidence was found suggesting that a dualleadership structure was effective in increasing the amount of debt in a firm's capital structure.Keywords Corporate governance, Senior management, Leadership, Shares

Introduction Agency theorists have long recognized that the separation of ownership and control common in mostcorporations creates conflicts of interest between a firm's managers and shareholders. These conflicts (agencyproblems) arise because managers have the opportunity to use the assets of the firm in ways that benefitthemselves personally but decrease the wealth of the firm's shareholders. Examples of this type of opportunisticbehavior by managers include consuming an excessive amount of perks, shirking of their responsibilities, andinvesting in negative net present value (NPV) projects that offer personal diversification benefits to the firm'smanagers. Amihud and Lev (1981) and Friend and Hasbrouck (1988) believe that some of this opportunisticbehavior results because many managers have large proportions of their personal wealth invested in their firm'scommon stock and in firm -specific human capital. Because their personal wealth is heavily invested in their employers, these managers will lose a large part of the their personal wealth if their employer goes bankrupt.Risk-averse managers may seek to mitigate this risk by acting to reduce the bankruptcy risk of the firm. Friendand Hasbrouck (1988) suggest that one way to accomplish this is to use less than the optimal amount of debt in

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the firm's capital structure. Further, the authors argue that the greater the proportion of personal wealth thatmanagers have tied up in the firm's common stock and firm -specific human capital the greater their incentive tominimize the use of debt in the firm's capital structure.Friend and Lang (1988) and Berger et al. (1997) tested to see if there is a relationship between managerialwealth invested in the firm and the amount of debt in the firm's capital structure. Friend and Lang (1988) usedas their measures of managerial wealth invested in the firm the proportion of the firm's common stock owned bythe firm's largest insider and the market value of the largest insider's stock holdings. They found an inverserelationship between both of these variables and the amount of debt in the firm's capital structure. However, themarket value of the insider's shares was found to be more strongly correlated with the amount of debt in thefirm's capital structure. Friend and Lang (1988) also found that the presence of a blockholder, one who ownedat least 10 percent of the firm's common stock, was associated with higher levels of debt financing by the firm.Berger ei al, (1997) also found that the presence of a blockholder (5 percent) is associated with higher levels of debt financing. Neither of the previous studies investigated whether the number of blockholders or the totalshare ownership of blockholders affects the amount of debt financing a firm employs. Berger ef al. (1997) alsofound that the percentage of a firm's shares owned by the CEO (chief executive officer) is directly related to theamount of debt in a firm's capital structure. This is in conflict with results reported by Friend and Lang (1988).In this study, I seek to expand on the previous research by seeking to resolve the conflict over the relationshipbetween managerial share ownership and firm debt financing, by testing for the effect of the number of blockholders and total blockholder share ownership on the amount of debt in the firm's capital structure, and byseeking to ascertain whether there is a relationship between firm leadership structure and the amount of debtfinancing the firm employs. I found that both the percentage of shares owned by the CEO and other officers anddirectors are inversely related to the amount of debt financing a firm employs. Further, it was found that theamount of debt in a firm's capital structure is directly related to total blockholder share ownership and isinversely related to the number of blockholders a firm has. Some weak evidence was found that indicates that

firm leadership structure influences the amount of debt in the firm's capital structure. The remainder of this studyis organized as follows. section I contains a discussion of the theories to be tested while section Il presents thesample selection procedures used in this study. The empirical results are contained in section III and asummary of findings is presented in section IV.Debt financing and its determinantsMost firms use some debt in their capital structure. The primary reason for doing so is that the tax deductibilityof interest lowers the cost of debt financing and makes debt capital the cheapest type of outside financingavailable to most firms. The major disadvantage of debt financing is that it increases the risk that the firm will gobankrupt if it can not service its debt. This bankruptcy risk is not particularly worrisome for an investor who holds

a well diversified portfolio of investments because the bankruptcy of any one firm in their portfolio of investmentswill not have a large impact on their wealth. Consequently, a well diversified investor will prefer that most firmsuse significant amounts of debt capital in their capital structures. Amihud and Lev (1981) and Friend andHasbrouck (1988) believe managerial insiders (officers and directors) have a somewhat different perspectivesince many of them have large portions of their personal wealth invested in their employers. The personalwealth a managerial insider has invested in their employer is composed largely of their employer's commonstock and the firm -specific human capital they have accumulated while working for their employer. Becausethese items tend to represent a large proportion of an insider's total wealth, the bankruptcy of their employer would have a major impact on their personal wealth. As a result, Friend and Hasbrouck (1988) argue thatmanagerial insiders should be much more sensitive to the bankruptcy risk debt financing induces and may beinclined to minimize this risk by using less than the optimal (shareholder wealth maximizing) amount of debt inthe firm's capital structure. Further, the more wealth a managerial insider has invested in their employer thegreater the incentive they have to minimize the use of debt financing.


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The shareholders problem is to make certain that managerial insiders do not succumb to their own personalfinancial incentives and use less than the optimal amount of debt in the firm's capital structure. In this study, theability of two mechanisms to control this agency problem are examined. These mechanisms are shareownership by blockholders and a dual leadership structure. Shareholders of a corporation have a residual claimon the earnings and assets of the firm and therefore bear, proportional to their share ownership, the economicconsequences of actions taken by the firm's managers and directors. If managerial insiders engage inopportunistic behavior, shareholders bear a pro rata share of the costs of such actions. Consequently, ashareholder's incentive to monitor insiders and make certain the firm is being properly managed is directlyrelated to the proportion of the firm's shares that the shareholder owns. This implies that a particular type of shareholder, blockholders (those who own at least 5 percent of a firm's common stock), have a strong incentiveto seek to control the opportunistic behavior of the firm's insiders. Consequently, greater blockholder shareownership in a firm should lead to greater monitoring of the firm by blockholders and result in more debtfinancing being used by the firm than its managerial insiders desire.

Another way to ensure that managers use the optimal amount of debt in the firm's capital structure is to havethe firm employ a dual leadership structure. A dual leadership structure is one in which the chair of the board of directors and the CEO positions are not held by the same person. The rationale for this was suggested first byFama and Jensen (1983). Fama and Jensen (1983) define decision management as the right to initiate andimplement new proposals for the expenditure of the firm's resources and decision control as the right to ratifyand monitor those proposals. By not allowing an insider to have both decision management and decision controlauthority over the same proposals, a series of checks and balances are imposed that make it more difficult for managerial insiders to engage in any type of opportunistic behavior. At the highest levels, this implies that theperson with the senior decision management authority (the CEO) should not be allowed to exercise the senior decision control authority as well. Since the board of directors is the highest level decision control structure inthe firm, this requires that the board must not be under the control of the CEO. If the board is controlled by the

CEO, "this signals the absence of separation of decision management and decision control ..." (Fama andJensen, p. 314). Since the chairman has the greatest influence over the actions of the board, the separation of decision management and decision control is com promised when the chairman of the board is also the CEO of the firm. Thus, requiring the chair and CEO positions to be held by different people (a dual leadership structure)should more effectively control the agency problems associated with the separation of ownership and controltypical in the modern corporation. Therefore, firms with a dual leadership structure should be more likely toemploy the optimal amount of debt in their capital structures than firms in which the CEO is also the board chair (a unitary leadership structure).

Alternately, managerial share ownership could also provide managers with an incentive to use the appropriate

amount of debt in the firm's capital structure. Managers who own shares of their company suffer wealth losses ( just like other shareholders) if the firm uses less than the optimal amount of debt financing. Since these wealthloses are proportional to managers' share ownership, the more shares managers own the more wealth theylose if they do not employ the optimal amount of debt financing. Therefore, the more shares managers own thegreater their incentive not to engage in wealth reducing activities like suboptimal debt usage. Whether the riskreduction incentive or the wealth loss incentive is the stronger motivator of managerial behavior is an empiricalquestion.Sample selectionBecause only about 15 percent of firms actually employ a dual leadership structure, any random sampleselection procedure is likely to result in few dual leadership firms being included in the set of sample firms.Consequently, to ensure that an adequate number of dual leadership firms enter the set of sample firms used inthis study a matched -pair sample selection procedure is employed. The firms used in this study were takenfrom the Business Week executive compensation studies. Each year Business Week reports the annual


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compensation and the titles held by the two highest paid executives of approximately 350 of the largest UScorporations. For each year from 1990 through 1996,1 construct a sample of firms matched by leadershipstructure, size, and industry classification. To be included in the sample for a given year, a firm with a dualleadership structure and a firm with a unitary leadership structure had to be found that were of approximatelythe same size (measured by sales) and were in the same Business Week industry grouping. Each firm was alsorequired to have the same leadership structure and the same CEO for the sample year (year O) and theprevious year (year -1). And lastly, all necessary data had to be available for both firms. Data used in this studywas obtained from Business Week, Forbes, and Disclosure. This procedure yielded a sample of 142 firms, half with a dual leadership structure and half with a unitary leadership structure. Firms in the banking industry werenot included in this study.Summary statistics for selected variables for the sample firms are contained in Table I. As expected, the samplefirms are quite large, with mean sales (total assets) of $4.909 ($5.493) billion. The firms had moderate amountsof debt in their capital structures as indicated by their mean long -term debt divided by the book value of common stockholder's equity ratio (debt/equity) of 0.9 499 4. On average, the sample firms are also profitable,with a mean three year average return on equity (average ROE) of 17.4 percent. The sample firms' CEOs owna mean 1.32 percent of their firm's common stock and other officers and directors have a mean shareownership of 5.84 percent. Blockholders (those owning 5 percent or more of the firm's shares) own, on average,16.8 percent of their firm's common stock. There are, on average, 1.72 blockholders per sample firm.Empirical analysisWe begin the empirical analysis by ascertaining if managerial insider wealth invested in the firm is correlatedwith the amount of debt in the firm's capital structure. Two measures of insider wealth are employed, thepercentage of the firm's common stock owned by the firm's CEO and the percentage of the firm's shares ownedby other officers and directors. First, the sample firms were ranked by CEO share ownership and placed intoshare ownership quartiles. The mean value of the debt/equity ratio was calculated for the firms in each quartile.

The results of this analysis are presented in panel A of Table II. The data indicate that the mean value of thedebt/equity ratio declines as the level of CEO share ownership increases. For example, the mean debt/equityratio for firms in the first quartile (those with the lowest CEO share ownership) is 0.623 as compared to a meanof 06 .268 for firms in the fourth quartile (those with the highest CEO share ownership). The difference in themeans of 0.355 is statistically significant at the 00 .0 01 level. The sample firms were then ranked by other officers and directors share owner ship, placed into share ownership quartiles, and the mean value of thedebt/equity ratio was calculated for the sample firms in each quartile. The results of this sorting are contained inpanel B of Table II. The data indicates that the mean value of the debt/equity ratio generally declines as other officer and director share ownership rises. For example, the mean debt/equity ratio for the firms in the first

quartile (those with the lowest other officer and director share ownership) is 0.578 compared to 0.345 for firmsin the fourth quartile. The difference between the means of 0.233 is significant at the 00 .0 05 level. Both of theabove results support Friend and Hasbrouck's theory that debt usage and insider share ownership are inverselyrelated.


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Next, the sample firms were ranked by blockholder share ownership and grouped into share ownershipquartiles. The mean value of the debt/equity ratio was calculated for each quartile and the results of thisanalysis are presented in panel A of Table III. Here, the mean debt/equity ratio generally increases asblockholder share ownership rises. Specifically, the sample firms in the first quartile (those with the lowestblockholder share ownership) have a mean debt/equity ratio of 0.438 while the firms in the fourth quartile havean average debt/equity ratio of 0.788. The difference in means of -0.350 is significant at the 0.10 level. Thisresult indicates that greater share ownership by blockholders can mitigate the ability of managerial insiders touse less than the optimal amount of debt in the firm's capital structure.


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Lastly, the ability of a firm's leadership structure to reduce the opportunistic behavior of insiders was examined.

As expected, the mean debt/equity ratio of firms with a dual leadership structure ( see panel B of Table III) ishigher than it is for firms with a unitary leadership structure (0.551 versus 0.438). The difference in means,however, is not statistically significant.

As a further empirical test, a regression analysis was performed using the data from the sample firms. Thedependent variable used in this analysis is the debt/equity ratio of the sample firms. The results of this analysisare contained in Table IV. Three control variables, total assets, sales, and average ROE, are used in theregressions. Total assets and sales were used as a size proxies. These variables are included because larger firms are thought to have better access to the credit markets and, therefore, should tend to have more debt intheir capital structures than smaller firms. The three year average return on equity (average ROE), a profitability

measure, is used because the more profitable a firm is the less need the firm should have for outside debtfinancing. To account for leadership structure differences among the sample firms, a binary variable (dual) isemployed. Dual takes on a value of one if the firm has a dual leadership structure and zero otherwise. The other independent variables used are as previously defined, unless noted otherwise.The coefficients of the size proxies, total assets and sales, are positive and statistically signifi cant at the 0.01level in both regressions. This supports the presumption that larger firms have better access to the creditmarkets. The coefficients of the profitability measure, average ROE, are negative (as expected) but are notsignificant in either regression. The next independent variable, CEO, has coefficients that are negative andstatistically significant at the 00 .0 05 level or better in both regressions. The coefficients of other officers anddirectors are both negative and significant at the 0.05 level. These results support our previous findings thatinsider share ownership and debt financing are inversely related. The coefficients of blockholders are positiveand significant at the 0.01 level in both regressions. This supports the contention that block holders are effectivemonitors of the firm's managers and directors and that they force managerial insiders to use more debt in thefirm's capital structure than the insiders personally desire. The number of blockholders is also employed as anexplanatory variable. We expect the coefficient of this variable to be negative because, holding blockholder share owner constant, the greater the number of blockholders the firm has the smaller the share ownership of each blockholder and the less incentive a blockholder has to monitor the firm's officers and directors. Thecoefficients on number of blockholders are negative and significant at the 00 .0 01 level in both regressions. Asin the case of the univariate analysis, firms with a dual leadership structure are found to have higher debt/equity

ratios. However, the relationship is not statistically significant.


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ConclusionFriend and Hasbrouck (1988) theorize that managerial insiders (officers and directors) have a personalincentive to cause the firm to use less than the optimal amount of debt in its capital structure. They suggest thisoccurs because officers and directors have a large proportion of their personal wealth invested in the firm in theform of common stock holdings and firm -specific human capital. This makes managerial insiders reluctant touse the optimal amount of debt financing for the firm because of the additional bankruptcy risk higher levels of debt engender. I test Friend and Hasbrouck's (1988) theory and find evidence that supports it. Specifically, theamount of debt in the sample firms' capital structures is found to be inversely related to the percentage of thefirm's common stock held by the CEO. This result indicates that CEOs will, in some instances, put their personalinterests ahead of the those of the firm's shareholders. As a consequence, shareholders and the board of directors must be vigilant in monitoring managers to make certain they perform as shareholders desire. Further,a direct relationship is found between blockholder share ownership and our sample firms' debt/equity ratio.

Additionally, for any given level of blockholder share ownership, the greater the number of blockholders a firmhas the less effective blockholders are in raising the amount of debt in the firm's capital structure. These resultssuggest that monitoring by blockholders is effective in controlling at least some agency problems and thegreater the share ownership of individual blockholders the more effective a monitor the blockholder becomes.This implies that shareholders can help protect their investments in a firm by encouraging individuals,institutions, and/or corporations to invest in large blocks of common stock of the firm.Lastly, some weak evidence was found suggesting that a dual leadership structure was effective in increasingthe amount of debt in a firm's capital structure. The effectiveness of a dual leadership structure in controlling theopportunistic behavior of managers is of more than academic interest as recent corporate governance scandals

at several major US corporations attest. The most prominent companies involved in these governance failuresinclude Enron, Tyco, and Adelphia Communications. In each of these instances, the managerial malfeasanceoccurred at a firm where the CEO was also the chairman of the board (a unitary leadership structure). Theresults reported in this paper suggest that the likelihood of these types of managerial malfeasances occurring


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could be reduced if firms adopted a dual leadership structure. Recently, a blue ribbon panel organized by TheConference Board concurred. The Commission on Public Trust and Private Enterprise, composed largely of prominent business executives and government officials, recommended that firms consider adopting a dualleadership structure as one means of preventing corporate governance breakdowns like the ones cited above.References

References Amihud, Y. and Lev, B. (1981), "Risk reduction as a managerial motive for conglomerate mergers", Bell Journalof Economics, Vol. 12 No. 2, pp. 605-17.Berger, P., Ofek, E. and Yermack, D. (1997), "Managerial entrenchment and capital structure decisions",Journal of Finance, Vol. 52 No. 4, pp. 1411-38.Fama, E. and Jensen, M. (1983), "Separation of ownership and control", Journal of Law and Economics, Vol. 26No. 2, pp. 301 -25.Friend, I. and Hasbrouck, J. (1988), "Determinants of capital structure", Research in Finance, Vol. 7 No. 1, pp. 1-19.Friend, I. and Lang, L. (1988), "An empirical test of the impact of managerial self -interest on corporate capitalstructure", Journal of Finance, Vol. 43 No. 2, pp. 271-81.AuthorAffiliation

Richard Fosberg is at William Paterson University, Wayne, NJ,Tel: (973) 720 -2434E-mail: [email protected]

Subject Corporate governance; Leadership; Studies; Debt financing; Upper management;

Location United Kingdom, UK Classification 9175: Western Europe; 9130: Experimental/theoretical; 2200: Managerial skills; 2110: Boards

of directors; 3100: Capital & debt management Publication title Corporate Governance Volume 4 Issue 1 Pages 31+ Number of pages 8 Publication year 2004 Publication date 2004 Year 2004 Publisher Emerald Group Publishing, Limited Place of publication Bradford Country of publication United Kingdom Publication subject Business And Economics--Management ISSN 14720701

Source type Scholarly Journals Language of publication English


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