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Chapter 3 Previous Empirical studies and Hypotheses development

3.3 Ownership characteristics and Capital Structure

3.3.2 Management ownership

The Boards of Directors are responsible for setting the compensation packages for the

CEO and themselves, indicating a potential area for compensation manipulation to occur

(Laux, 2008). Corporate scandals, such as Enron, and more recently in 2013 Save the

Children, have fueled the concern over the compensation packages of the Board of

Directors. Whilst the shareholders may have delegated away from the agency problems,

the directors become the agents, and their interests may not align with the shareholders.

The conflict is present in situations whereby a director’s career is linked to the CEOs; this can present an issue for NEDs, however to a lesser extent (Ozkan, 2007).

Management ownership can be associated with managerial entrenchment. The absence of

effective monitoring and disciplining mechanisms can lead to companies having poor

corporate governance, enabling the gap between the manager and shareholder objectives

to widen. The existence of suboptimal strategies is likely in companies with poor

corporate governance. For example, managers being seen as indispensable, performance

measures being manipulated, and the resistance of takeovers (Shleifer and Vishny, 1997).

One study finds that internal corporate governance mechanisms, such as managerial

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managerial entrenchment and therefore agency costs (Florackis and Ozkan, 2009).

Florackis and Ozkan (2009) find that agency costs persist over time; the study identifies

how corporate governance devices interact with each other and how they should not be

analysed in isolation. Previous research on the existence of entrenchment in companies

demonstrates lower than optimal leverage levels (Berger et al., 1997; De Jong and Veld,

2001; Brounen et al., 2006). Chen and Steiner (1999) find a positive and significant

relationship between risk and managerial ownership. Managerial ownership is a

determinant of risk, the increase in monitoring is seen as reducing the agency conflict

between shareholders and managers. Management ownership is seen as a function of risk

in addition to a determinant of risk (Chen and Steiner, 1999); therefore, the relationship is

two way.

The results will have important implications to the macroeconomics, the pursuit of

positive net present values projects leads to company growth, a key goal of companies.

Grossman and Hart (1982) state that the presence of debt in the company’s capital structure encourage managers to become more efficient, reducing the threat of

bankruptcy, and therefore managers avoid the loss of control and the loss of their

reputation. The balance between debt and equity requires careful management; a capital

structure containing too much debt can increase the agency costs of debt in the form of a

risk shifting incentive. Risk shifting occurs in situations whereby companies increase

their levels of debt, shareholders also increase their risk levels, and the uptake of riskier

projects by companies is preferred. The uptake of riskier projects enables the debt to be

paid off more quickly, and shareholders can gain the excess once the debt has been

repaid. The failure of projects, results in the debtholders bearing the cost of the higher

risk debt levels (Bathala et al., 1994). The increase in debt levels in the company can

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managers. Short-term myopic and share price volatility is increased through high levels

of managerial ownership. High levels of managerial ownership can result in

entrenchment problems, if directors hold a managerial interest in the company it can

result in the failure of voting and takeover activities.

McConnell and Servaes (1990) find how the relationship between managerial ownership

and company performance increases at low levels of ownership, while it decreases at high

levels of ownership. The focus of this study is on the relationship between managerial

ownership and capital structure, which has been under-researched in a UK context. The

results indicate how an optimal corporate governance structure may exist; however, this

differs for different companies due to each company facing different management issues,

and therefore solutions. How managers exercise their options is dependent on company

performance; there are two reasons behind this. The first reason is as share price

increases it will encourage directors to exercise their share options, while choosing not to

exercise their options if share prices fall. The second reason concerns the level of

information directors have; directors with information that the company has good future

prospects will purchase more shares, while they will sell shares if they have poor

information (Bebchuk and Fried, 2003). The responsibility of setting the compensation

packages for the Board of Directors lies with the compensation committee, which often

contains directors for whom compensation packages are being decided upon.

The relationship between capital structure and shares held by the Board of Directors over

a ten-year period is relatively undiscovered in a UK context. Harris and Raviv (1988),

and Stulz (1988) state how managers increase their leverage levels in order to temporarily

inflate shareholders voting power, therefore decreasing the requirement for corporate

control by the market. Fama (1980) and Jensen (1986) find how managers prefer to

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wealth, which may be under-diversified. The two consequences of managerial

entrenchment lie firstly in the lack of monitoring (Jensen, 1993) that is undertaken by

boards with a high level of managerial ownership. Secondly, the protection from hostile

takeover bids (Stulz, 1988) that high managerial ownership creates. The presence of

large shareholders on the Board of Directors should aid to reduce the agency costs; these

shareholders may be undiversified, which could lead to an aversion to debt. Meanwhile,

if these shareholders are banks, then they may encourage companies to borrow from

banks. The fear of being taken over could result in companies taking on more debt to

make the company less attractive (Stulz, 1988).

Agency theory (Jensen and Meckling, 1976) is the main theory underlying studies that

analyses the relationship between the percentages of shares held by the Board of

Directors, and the impact of this on key corporate finance decisions. Agency costs are

created through the process of trying to reduce the conflict of interest that is present

between shareholders and managers having different goals. One solution to reducing the

agency costs is through management, i.e. Board of Directors, having shares in the

company as part of their compensation package. Share ownership is seen as a solution to

mitigating the agency costs, and aligning the two party’s goals. 3.3.2.1 Board Ownership Hypothesis

Jensen and Meckling (1976) agency’s theory can be attributed to the percentage of managerial ownership, which can align the interests of shareholders and managers. The

‘convergence of interest hypothesis’ identifies how an increase in managerial ownership can increase the performance of the company; managers are less likely to use resources

for their own consumption and focus on share maximisation. In contrast Fama and

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maximisation at low levels of share ownership. While Morck et al. (1988) find that high

levels of managerial ownership can led to managerial entrenchment.

Evidence from a UK study (Short and Keasey, 1999) over the period 1988 to 1992 find

management become entrenched at a higher level of share ownership, in comparison to

the US. In particular management owning between 12% and 40% are shown to have a

negative impact on performance. However, positive relationships are found by Leland

and Pyle (1977); Berger et al. (1997), and indicate inconsistencies. The impact on debt

levels of managerial share ownership is undiscovered, and the focus of this study to

identify whether the solution to reducing the agency costs can influence the company’s

capital structure.

The relationship between managerial ownership and performance is not the focus of the

study; the focus is on the relationship between managerial ownership and capital

structure. A study by Chen and Steiner (1999) link levels of risk to managerial

ownership, the study finds a substitution monitoring effect occurring between managerial

ownership and the debt policy. Debt is seen as riskier than equity, indicating a negative

relationship between managerial ownership and leverage levels. The use of debt as

opposed to new equity does dilute the existing shareholders ownership, and presents a

different shareholder base. The use of shares as a financial reward to the Board of

Directors does depend upon the share price, and how volatile it is.

The relationship between managerial share ownership and leverage will be considered in

this study, to identify whether a relationship exists as proposed by a previous study

(Faccio et al., 2012) of private companies. In line with managerial entrenchment

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relationship is expected in this study. The higher levels of managerial ownership enable

managerial entrenchment to occur, and therefore the impact is on lower leverage levels.

The hypothesis is:

H13: There is a negative relationship between the number of shares held by the Board of Directors and leverage.