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.