The Influence of Institutional Investors on Corporate Management and Corporate Governance in Germany

Table of Contents

Table of Contents

List of Abbreviations

Table of Figures

List of Tables

1. Introduction

2. Methodology

3. Theoretical Differentiation of the Object of Investigation
3.1 Shareholder Activism
3.2 Investors
3.2.1 Institutional Investors
3.2.2 Non-Institutional Investors
3.3 Corporate Governance
3.4 Corporate Management

4. Shareholder Activism by Institutional Investors in Germany – Status Quo
4.1 The Growth of Institutional Share Ownership
4.1.1 Renunciation from the “Wall Street Walk”
4.1.2 Liquidation of “German Inc.”
4.2 The Principal – Agent Theory and Agency Costs
4.2.1 The Principal – Agent Conflict in Listed Companies
4.4.2 Shareholder Activism as a Method to Solve the Agency Problem
4.3 Demands of Institutional Investors on Corporate Governance
4.4 Importance of Instruments used by Institutional Investors
4.4.1 External Instruments
4.4.2 Internal Instruments
4.5 Intermediary Result

5. Explanatory Models for Shareholder Activism by Institutional Investors
5.1 Single-Variable Explanation Approaches
5.1.1 Size of Stakes and Cross Holdings
5.1.2 Legal Explanations
5.1.3 Aftermarket Liquidity
5.1.4 Portfolio Management
5.2 Multi-Variable Explanation Approaches
5.2.1 The Model of Shleifer and Vishny
5.2.2 The European Governance Network Approach
5.3 Intermediary Result

6. The Corporate Governance System in Germany
6.1 The Need for Information versus the Protection of Information
6.2 Direct Firm Level Monitoring
6.2.1 Institutional Investors and the German Annual General Meeting
6.2.1.1 Commercial Banks
6.2.1.2 Mutual Funds
6.2.1.3 Insurance Companies
6.2.2 Indirect Firm Level Monitoring
6.2.2.1 Takeovers or the Market for Corporate Control
6.2.2.2 Board Composition and Board Structure in Germany
6.2.3 Institutional Investors and Board Independence
6.3 Implementation of the German Corporate Governance Code
6.4 Corporate Governance in an International Context
6.5 Intermediary Result

7. Empirical Results on the Success of Activism by Institutional Investors
7.1 Evidence on the Effects of Shareholder Activism in the USA
7.2 Evidence on the Effects of Shareholder Activism in Germany

8. Summary and Perspectives

Bibliography

Appendix A

Appendix B

Appendix C

List of Abbreviations

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Table of Figures

Figure 1: Classification of institutional investors by the OECD

Figure 2: Investments and holdings of German institutional investors

Figure 3: Investments and holdings of German institutional investors in bn €

Figure 4: Development of public and special funds in Germany

Figure 5: Development of (direct) stock ownership vs. investment fund owners

Figure 6: Network of “German Inc.” in 1996

Figure 7: Network of “German Inc.” in 2004

Figure 8: The standard model of the principal-agent conflict

Figure 9: Determinants of the capital market linkage

Figure 10: Factors on which institutional investors select their holdings

Figure 11: Board composition by category of director

Figure 12: Academic evaluation of Shareholder Activism in the USA

List of Tables

Table 1: Quantity of investment funds in Germany

Table 2: Objectives of the management vs. objectives of shareholders

Table 3: Attendance rate of shareholders at German annual meetings in percent

Table 4: Typology from ECNG

Table 5: Evaluation of shareholder activism by institutional investors

1. Introduction 1

Corporate management and corporate governance are becoming more and more crucial in today’s successful economies. With the increasing relevance of capital markets this sub­ject comes more into the focus of the public. Particularly, the fast growing importance of institutional investors is a key factor which helps to explain the changing attitude of man­agers towards shareholders and corporate governance.

In conjunction with the German capital market, a wide variety of mismanagement in German public limited companies has revealed shortfalls of German top-management and corporate control in the last decade. This development was of fundamental importance for the development of the German Corporate Governance Code. Hence, the basic underlying of corporate governance can be attributed to a conflict between the management of a listed corporation and its owners. More precisely, this conflict arises because the management does not adequately comprise the interests of shareholders.

In Germany, assets under management of professional investors have increased at 92 percent from 1990 to 2001.¹ In addition, a growing administration of private savings by professional fund managers as well as the intensified exercise of influence by institutional investors on corporate governance and corporate management respectively corporate strat­egy is observable. Similarly, a growing importance of institutional investors could be ob­served in the United Kingdom as well as in the United States.

Within academic literature, the issue of activism by institutional investors in Germany is analyzed little, so far. Furthermore, there are only a few surveys on the outcome of the influence by institutional investors on corporate management. Therefore, this thesis aims to answer the following questions:

1. How was the development of shareholder activism in Germany and how can it be characterized and explained?
2. Is shareholder activism a superior tool in relation to the market of corporate control to solve the principal-agent problem?
3. What do institutional investors demand from German corporations and in particular from corporate management?
4.Which options do institutional investors have to influence corporate management?
5. How are these options for activism covered by the German Corporate Governance Code and the German legal framework?
6. What is the optimum corporate governance from an institutional investor’s angle?
7. What is the empirical outcome of activism by institutional investors in Germany?

2. Methodology

In order to answer the question asked above, this thesis will be structured as followed:

Chapter 3 will start with the elaboration on fundamentals which are necessary for the introduction to the topic of the thesis. Particularly, definitions of shareholder activism, in­stitutional investors as well as corporate governance and corporate management will be given.

The objective of chapter 4 is to outline the historical development of investor activism in Germany. Hence, evidence will be given on growing institutional ownership. Addition­ally, several explanations for this development will be outlined as for example the renun­ciation from the “Wall Street Walk”, the liquidation of “German Inc.” and most important the principal-agent conflict. Finally, chapter 4 will present requirements and demands of institutional investors on German corporate management. In this context, internal and ex­ternal instruments will be presented to achieve these demands.

Chapter 5 will provide explanatory models for shareholder activism. In more detail, single variables, e.g. voting rights and aftermarket liquidity will be outlined and evaluated. In contrast to single variable explanations, two multi-variable explanatory models, namely the model of Shleifer and Vishny and the European Governance Network approach, will be opposed to single-variable approaches.

The objective of chapter 6 is to outline the German legal framework under which cor­porations as well as institutional investors operate. In that context, the German Corporate Governance Code will be applied accessorily. Moreover, this chapter will elaborate on direct firm level monitoring and in particular the legal framework under which institutional investors operate at general annual meetings. However, due to inconsistencies of institu­tional investors - mutual funds, commercial banks and insurance companies will be exam­ined separately. Furthermore, indirect firm level monitoring and in particular the market for corporate control as well as board composition and board independence will be evalu­ated. Finally, the chapter will close with an empirical assessment of the German Corporate Governance Code and with a reflection of corporate governance in an international con­text.

In a final step, chapter 7 will present empirical evidence on the success of activism by institutional investors. To sum things up, chapter 8 will summarize the main findings and will present promising starting points for further research.

3. Theoretical Differentiation of the Object of Investigation

This chapter will provide a basis of fundamentals which are necessary for the elabora­tion of the problems, which are dealt with in this thesis. In a first step, the basics of share­holder activism will be outlined. For the further development, it is essential to distinguish different kinds of investors. In addition, it is necessary to explain and define the terms cor­porate governance and corporate management.

3.1 Shareholder Activism

Historically, Shareholder Activism is not a new phenomenon. The first documented shareholding dates back to the year 1288. Since then, shareholders had access to the most basic “instrument” of activism, namely, to vote relative to their shareholdings on corporate issues like, personnel or initiatives.²

At first glance, the expression “Investorenaktivismus” is barely widespread in German literature. Consequently, it follows that there is no standard definition of this term. Even in English literature, where investor activism is a synonym for shareholder activism, it is hard to find a common prevalent definition. For instance, Nicolai and Thomas characterize shareholder activism as: “[...] die Einflussnahme von Anlegern auf die Corporate Govern­ance und Führung von börsennotierten Unternehmen” ³, respectively the influence on cor­porate management.⁴ Taking a look on English literature, Smith defines shareholder activ­ism as a “[...] attempt to bring about changes in the organizational control structure of firms (targets) [...]” which is “[...] not perceived to be pursuing shareholder wealth maximizing goals.” ⁵

Furthermore, Black defines shareholder activism as: “[...] proactive efforts to change firm behavior or governance rules.”⁶ Becht et al. view shareholder activism as a divisive issue because it corresponds to a range of actions from shareholders to influence corporate management and boards of their holdings. These actions can range from threatening to sell shares, letter writing as well as informal meetings with the management or board. Addi­tionally, it includes asking questions at the annual general meeting and it definitely in­cludes the exercise of voting rights. ⁷

The attentive reader might realize that there is a diversity of possible definitions, al­though they adhere to the same content. For the further procedure, shareholder activism is conceived as: proactive exercise of influence by shareholders on corporate management to achieve individual objectives. Furthermore, the term shareholder and stockholder will be used as synonym for the term investor.

Shareholders of a listed company acquire a share in the company’s equity by buying shares on the stock market. Stockholders are not entitled to interests nor do they have a right to redemption. With the purchase of shares, stockholders are only entitled to profit sharing (if there is a profit) as well as to vote on corporate issues if these issues are put on the agenda at the annual general meeting (further AGM). Hence, stockholders can exercise their voting rights at the AGM, which has to take place at least once a year.⁸

But shareholders are not the only stakeholders who try to achieve their own goals. Typi­cally, shareholders have the interest to at least, receipt their money but more to increase their property and the value of their assets. These claims refer to the shareholder value concept which basically demands to solely manage the company in the best interests of the shareholders and, thus, to maximize the market value of the outstanding shares.⁹

3.2 Investors

Whether investors actively influence corporate management depends on the type of in­vestor one is referring to. Generally speaking, investors are characterized as individuals or firms who undertake investments.¹⁰ In addition, investments can be categorized into the fields of capital appropriation, e.g. the disposal of financial resources to acquire tangible and intangible assets as well as financial assets.¹¹

Within the field of science, the term investor can be systematically split up into different sub-groups. Some authors differentiate between institutional investors on the one hand and private or individual investors on the other hand.¹² Contrary, Deutsche Bundesbank classi­fies investors into financial and non-financial sectors. Additionally, Deutsche Bundesbank differentiates between foreign investors (rest of the world) and domestic investors.¹³ Thus, institutional investors and non institutional investors will be specified in more detail.

3.2.1 Institutional Investors

Institutional investors are becoming more and more important in today’s modern capital and stock markets.¹⁴ On the one hand, this is due to the interplay between companies and their need to raise capital internationally. On the other hand, the growing importance can be explained by growing pools of assets, managed by institutional investors. Numerous individual investors around the world invest their money in products offered by institu­tional investors. These products range from mutual funds, pension funds as well as other retirement products which are mostly offered by insurance companies or banks respec-tively.¹⁵

According to the Organization for Economic Cooperation and Development (further, OECD) “institutional investors are major collectors of savings and suppliers of funds to financial markets.”¹⁶ Therefore, a detailed classification of institutional investors by the OECD is illustrated below.

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Figure 1: Classification of institutional investors by the OECD¹⁷

Following Schiereck, institutional investors are characterized by three main aspects: First, institutional investors act as an independent legal body. Second, their main business operations are alluding to the management and disposal of external finance through spe­cially trained employees. Lastly, institutional investors are characterized by their portfolio holdings which are labeled by an above average volume of orders, which is able to influ­ence financial markets.¹⁸

However, Deutsche Bundesbank defines institutional investors as investors who have enormous assets at their disposal and thereby using professional techniques to manage them.¹⁹ In a more narrow definition, Deutsche Bundesbank subsumes under the term “insti­tutional investors”: insurance companies, investment funds and pension funds. In addition, this definition is expanded by commercial banks and industry enterprises with substantial shareholdings. For the purpose of this thesis, institutional investors are understood as commercial banks, insurance companies, and mutual funds. In addition to that, a further distinction into foreign and domestic institutional investors is not subject to this analysis.

3.2.2 Non-Institutional Investors

According to Deutsche Bundesbank, non-institutional investors are physical persons like private households or individuals as well as public funds and non financial corpora-tions.²⁰

Private households can be classified into three sub-groups, namely retail customers, pri­vate banking customers and High Net Worth Individuals (further, HNWI). These groups are attended by commercial banks. It is noteworthy that HNWIs are very wealthy individu­als who are taken care of individually. Additionally, the boundaries between HNWIs and institutional investors are blurring.²¹ Nonetheless, private households are not subject to this analysis.

On the one hand, public authorities often engage indirectly into investment processes via refinancing, e.g. they give deficiency guarantees. On the other hand, public authorities also invest via medium sized investment companies directly. Although governmental in­vestment companies have a high potential to influence financial markets, this group (Staatsfonds) will be excluded from further investigations.²²

Last but not least, the European Union defines non-financial institutions as organiza­tions which provide non-market related products to private households. In particular, they are classified as follows:

– Unions, professional associations (Fachverbände), scientific associations, con­sumer associations, political parties, churches and religious communities as well as social and cultural associations, sport clubs and leisure clubs
– Charity associations as well as relief organizations (Hilfswerke) and foreign aid associations which are financed through unsolicited contributions in kind as well as through money²³

After distinguishing institutional and non-institutional investors, the terms corporate governance and corporate management will be introduced and defined.

3.3 Corporate Governance

Shleifer and Vishny define corporate governance as: “[...] the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment.”²⁴ From an academic point of view, this definition seems not to be sufficient and needs a more differentiated review.

Against a larger economic background, corporate governance is only a small fraction of the context in which companies operate. For example, other factors like economic policies as well as the degree of competition in factor and product markets influence the behavior of a company. Moreover, corporate governance frameworks around the world are shaped by different legal, regulatory and institutional conditions.²⁵ Taking the commentary on the German Corporate Governance Code, the term corporate governance denotes for the legal and factual regulation framework for the management as well as the framework for moni­toring a company. Thus, it is important that one can distinguish corporate governance be­tween an internal and an external perspective.

The internal perspective calls for the understanding of roles, competences and function­ality within the company. Beyond that, the internal perspective also arranges the interac­tion between different legal functions inside the company, especially the interaction be­tween the board of directors and the supervisory board. Contrary to the internal perspec­tive, the external perspective of corporate governance arranges the relationship between the management of a corporation towards their stakeholders and more particularly their share-holders.²⁶

In addition to the commentary on the German Corporate Governance Code, the OECD principles of corporate governance state that:

“Corporate governance involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders.” Moreover, “Corporate Governance also pro­vides the structure through which the objectives of the company are set, and the means of at­taining those objectives and monitoring performance are determined.”²⁷

Furthermore, the OECD principles adhere for a corporate governance framework that:

[...] should protect shareholder rights, which includes equitable treatment for all sharehold­ers including minority and foreign shareholders.” Additionally, the OECD principles call for an “ 1 ...] effective redress for the violation of (shareholders) rights.”²⁸

Last but not least, a functioning corporate governance framework does also help to in­crease the confidence in financial markets. Thereby, it lowers the cost of capital through a more efficient allocation of resources, which results in the strengthening of growth patterns in the whole economy.²⁹

Due to the complexity and quantity of worldwide existing corporate governance codes and different legal backgrounds, the author restricts the analysis to the German Corporate Governance Code. Hence, corporate governance is viewed as the mandatory framework for managing and monitoring a quoted corporation based on German law and on the German Corporate Governance Code. Thus, the main focus of interest will lie on the cooperation between institutional investors and management within this framework.³⁰

3.4 Corporate Management

Generally, and internationally common, the terms “Corporate Governance” and “Corpo­rate Management” have to be distinguished. As outlined above, corporate governance deals with the regulatory framework to manage a company and to monitor the management. In contrast, corporate management deals with the targeted impact on internal processes by the management.³¹

Corporate management can be differentiated on the basis of several dimensions. Thus, one can distinguish the following dimensions:

– Extent (partial or total),
– Procedure (synoptically or incrementally) and
– Paradigm (systematic or constructivist).

Based on the comprehensiveness of corporate management models, all sub-functions of the term corporate management will be dealt with. In particular, this thesis will emphasize on the sub-functions of corporate management, e.g. strategic planning and control aspects, information and communication, motivation and compensation as well as organizational and cultural aspects. Particularly, the embodiment of these functions from the perspective of institutional investors will be relevant.

4. Shareholder Activism by Institutional Investors in Germany – Status Quo

The objective of this chapter is to outline the historical development of investor activ­ism in Germany. Hence, it is necessary to present evidence on a growing institutional own­ership in Germany and to assign reasons for such a development.

4.1 The Growth of Institutional Share Ownership

After defining and outlining different kinds and aspects of German institutional inves-tors,³² it is necessary to proof the growing impact by providing data of the volume of assets held by institutional investors. Unfortunately, there is no single data pool available. There­fore, data are based on different sources, in particular from Deutsche Bundesbank, Bundesverband Investment and Asset Management e.V. (further, BVI) and Gesamtverband Deutscher Versicherungen (further, GDV).

However, figure 2 illustrates the development of German institutional investors from 2002 to 2007. Following the methodology from the OECD Statistical Yearbook, figure 2 shows the investments and holdings as a percentage of German GDP.³³

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Figure 2: Investments and holdings of German institutional investors³⁴

In 2007, equity holdings and share in affiliated companies of German institutional in­vestors amounted 109.7% of German GDP. The largest share is contributed by investment funds and investment companies, amounting to 59% of German GDP. German commercial banks are second in terms of their proportion on German GDP with 33.8%. Last but not least, German insurance companies are third with a share of 16.9 % on German GDP. Up to this point, the reader might not be able to evaluate the size and impact of these relative values. Therefore, figure 3 presents absolute numbers on institutional investors in Ger­many.

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Figure 3: Investments and holdings of German institutional investors in bn € ³⁵

As mentioned above, investment companies and investment funds are the most impor­tant group within the group of institutional investors with a compounded annual growth rate (CAGR) of 8.26%³⁶ and equity holdings with a total of 1,429 billion €. Banks are sec­ond with total holdings of 818.14 billion € and a CAGR of 4.85 percent.³⁷

Lastly, insurance companies are third with a total of 410 billion € and a CAGR of 2.48%. To allow for a more detailed analysis, and to stress the fact that mutual funds are the “major player”, table 1 provides information on the growing number of funds in Ger­many from 2000 to 2007.

Table 1: Quantity of investment funds in Germany³⁸

Abbildung in dieser Leseprobe nicht enthalten

Among the group of investment funds, public mutual funds are outstanding. In the time-frame from 2000 to 2007, the CAGR yields 4.9%, whereas the absolute growth is 33.1%. Pension funds do not play the same important role like in the U.S. or the U.K. This is partly due to a different retirement and, therefore pension system, in Germany, which is state-run.³⁹ Moreover, it has to be noticed that public and special hedge funds were first introduced respectively allowed by law in 2004. Hence, these funds do only play a minor role in the German financial landscape, so far.⁴⁰ Thus, hedge funds will not be part of a deeper analysis and will be disregarded.

A more interesting point is the development and composition of equity holdings be­tween public and special funds, which is illustrated in figure 4.

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Figure 4: Development of public and special funds in Germany ⁴¹

Starting in 1990, the fund industry ran through a remarkable development. In 1990, public funds started at a relatively low basis of 71.1 billion euro under their management. However, special funds, which are only open to non-natural persons,⁴² accounted for 57.8 billion euros under their management. In 2000, assets under management of special funds almost increased tenfold, whereas the assets of public funds increased by a factor of 6.2. Moving on, and having a look at the year 2007, one can realize that public funds still lead the fund industry with total assets under its management of 733.1 billon euro.

Nonetheless, special funds kept up with public funds and managed 695.9 billion euro in 2007. To some extent, this development can be explained by a rising interest of German citizen in investment funds or, in other words, in products offered by investment funds. On the other hand, the rise of the fund industry can be explained by synergies used by banks and insurance companies. In particular, insurance companies and banks invest part of their assets in investment companies and, thus, promoted this development.⁴³

At the beginning of this millennium, 10.6 million German citizens hold shares of public investment funds. In the year 2007, this number increased to 15.5 million.⁴⁴ The develop­ment of share ownership vs. investment fund ownership of German citizens is therefore illustrated in figure 5, which gives evidence of a clear upward trend towards investment fund ownership.

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Figure 5: Development of (direct) stock ownership vs. investment fund owners⁴⁵

In short, this section showed that institutional investors are on the rise in Germany. However, it was necessary to present that evidence before analyzing the impact of such a development on activism as well as on corporate governance and corporate management. A deeper analysis and reasons for that development will be dealt with in the following sub­sections.

4.1.1 Renunciation from the “Wall Street Walk”

Institutional investors like pension funds, commercial banks and insurance companies hold substantial fractions of shares in listed companies all around the world. As the reader might have noted, these fractions are increasing steadily from year to year in Germany.⁴⁶

In the past, institutional investors played only a limited role in overt forms of activism in Germany, e.g. takeovers, proxy fights, strategic voting, shareholders’ proposals, etc.⁴⁷ Only in the recent past and in conjunction with the takeover attempt by Deutsche Boerse AG, some forms of activism appeared before the public. In particular, Deutsche Boerse AG tried to take over the London Stock Exchange in 2005. After announcing the takeover at­tempt, one institutional shareholder, namely The Children’s Investment Management Fund (further, TCI), called for an extraordinary general meeting to dismiss the supervisory board of Deutsche Boerse AG. TCI considered that the price offered for the stocks of LSE was too high. Instead, they suggested a repurchase of own stocks.⁴⁸ As a result and in coalition with Fidelity Investments and an investment company of Merrill Lynch and others, more than 50 % of the shareholders ruled against the takeover attempt and voted for a repurchase of own stocks.⁴⁹

But, why is it that shareholders and especially institutional investors do not publicly act in such a manner more often? One possible explanation is the so called “Wall Street Walk” or “Wall Street Rule”. Based on the view of an individual shareholder, the “Wall Street Rule” indicates that if a shareholder is not pleased with the policy of his shareholding com­pany, he should sell all his shares rather than actively trying to change the company’s pol­icy. Nevertheless, Admati and Pfleiderer pointed out that “[...] the threat of exit itself can be a form of shareholder activism”.⁵⁰ If the manager’s compensation is depending on the actual stock price, a threat of selling all shares could negatively influence the stock price and therefore the bonus of a manager.

One likely explanation for inactive behavior of institutional investors is that sharehold­ers weigh costs and benefits. Even if an institutional investor is active he has to bear all costs, which can be significant. Contrary to the costs of such actions, he will only receive a fraction of the benefits which is only according to his amount of shareholding. Economi­cally, this phenomenon refers to the “free-rider problem”. In addition to the above outlined problem other factors like legal barriers and agency problems might also limit activism by institutional shareholders.⁵¹

However, the free-rider problem has been discussed in several disciplines of sciences for ages. The basic underpinning of the free-rider problem within the Self-Interest Theory, which belongs to the field of social science, is the assumption of self-interested actors. In that context, Hobbes argued that if a group of individuals is small enough, they might benefit from collective action and therefore act for mutual benefit. Contrariwise, if the group is too large, free riding is in the interest of all members.⁵²

Following Hobbes’s line of argumentation, and since German capital markets are char­acterized by concentrated ownership as well as by illiquidity,⁵³ which means that a poten­tial sale of shares will affect stock prices, one can conclude that activism by institutional shareholders could be beneficial. Whether this line of argumentation holds, or needs to be rejected, will be discussed in chapter 4.5.

4.1.2 Liquidation of “German Inc.”

The German capital market and in particular the German stock market does only play a minor role in relation to Anglo-Saxon stock markets.⁵⁴ In fact, there are manifold reasons for that discrepancy, but basically it can be attributed to legal and fiscal regulations.⁵⁵ However, the implementation of capital market reforms was one reason for a structural change of the German capital market.⁵⁶

A special characteristic of the German stock market is the capital- and individual related linkage between large German companies. This linkage is often referred to as “German Inc.” In more detail, “German Inc.” can be defined as a corporate governance system with a high proportion of equity and numerous interlocking participations, which allows for a system of “check and balances”. Thus, “German Inc.” is also called “controlling capital­ism,” whereas the Anglo-Saxon corporate governance system is called “liberal capitalism”. Some integral elements of such a “controlling” economy are long term financing relation­ships, protection against effective control through capital markets, e.g. the market for cor­porate control as well as the participation of employees on the supervisory board.⁵⁷

However, Hoepner and Krempel visualized the German capital market structure in order to outline those companies which are key players to the structure of “German Inc.”.

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Figure 6: Network of “German Inc.” in 1996 ⁵⁸

In 1996, several financial institutions, such as Deutsche Bank or Allianz, framed the centre of “German Inc.”. Due to these cross-holdings and interdependencies, it was possi­ble to “support” and protect each other from the market of corporate control.⁵⁹ Based on the same companies, figure 7 illustrates the network of “German Inc.”, in 2004. It is obvi­ous that a dramatically change has been taken place within 8 years.

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Figure 7: Network of “German Inc.” in 2004⁶⁰

Apparently, the network of “German Inc.” has been changed. Nevertheless, institutional investors, like insurance companies and commercial banks are still protagonists, although they substantially reduced their shareholdings. There are manifold reasons for the liquida­tion of “German Inc.” As already mentioned above, fiscal regulations and company law directives promoted this development. Furthermore, decreasing rates of return as well as a reorientation of commercial banks towards investment banking supported this process. In addition, this development went along with a reduction of personnel interdependencies between the companies.⁶¹

A further characteristic of the German capital market is concentrated ownership, or in other words, the relatively small dispersed ownership of shares.⁶² In 2004, 52.1% of all quoted companies had a controlling stockholder with voting rights accounting for more than 50%.⁶³ Additionally, 74.5% of all quoted companies in Germany had a single minor­ity stockholder whereas in the United States this number only accounts to 5 % of the com-panies.⁶⁴

Besides the process of the liquidation, it is also important to stress the fact that this de­velopment went along with an increasing institutionalization, i.e. the professional man­agement of private savings through professional investors.⁶⁵

As a conclusion, it can be stated that the German capital market, in comparison to the United States or the United Kingdom, is still underdeveloped. Nevertheless, it is clear that “German Inc.” does not exist anymore and that there is a slow movement towards liberal capitalism and, thus, more activism. In the following chapter, the theoretical background of investor activism, namely the agency theory, will be introduced and applied to the German capital market.

4.2 The Principal – Agent Theory and Agency Costs

Already in 1776, Adam Smith was one of the first economists who realized the problem resulting from the separation of ownership and power of control in listed companies:

“The directors of such companies, being the managers rather of other people’s money than their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own.” ⁶⁶

In 1932, Berle and Means showed in their famous work “The Modern Corporation & Private Property” that within American large-scale enterprises, stockholders do not have the influence and the power to influence corporate policy. In fact, this power lies within the hands of managers. Moreover, they proposed their famous thesis that the separation of ow­nership and control is even larger in public traded companies with a higher degree of dis­persed ownership than in companies which only have few stockholders.⁶⁷

However, the basic underlying of the agency theory can be linked to the contractual view on the firm⁶⁸ which basically defines a company as a construct composed of con­tracts. According to the theory, the principal mandates the agent to fulfill the principal’s orders on his behalf. Therefore, the principal is required to delegate some of his decision-making power to the agent,⁶⁹ albeit the risk of wrong decision making is left to the princi-pal.⁷⁰

The key elements of the principal-agent theory are two fundamental issues, namely a divergence of interests as well as an asymmetric distribution of information. An asymmet­ric distribution of information is assumed when the agent is better informed than the prin­cipal. Thus, the agent is able to act in an opportunistic manner in the face of the principals’ disadvantage. This action is referred to as moral hazard and can be explained by a lack of information of the principal.⁷¹ In almost the same manner, the agent is now able to use his information for his own purposes.⁷²

To overcome this divergence of interests as well as to keep the agent in line with the principals’ goals, it is necessary to take means. Obviously, these means are not for free and bear costs which, according to Jensen and Meckling, are called agency costs. Following Jensen and Meckling, agency costs can be classified as follows:

1. Monitoring costs are expenditures which the principal has to bear in order to su­pervise the agent’s actions.

2. Bonding costs are expenses which the agent has to contribute in order to signal the principal that he will act in the best interest of the principal, even though he has discretionary latitudes.

3. The principal has to bear a residual loss, which is composed of unavoidable oppor­tunity costs. Compared to the first-best solution and due to positive transaction costs from the assignment of the agent, this will lead to a lower profit.⁷³

With regard to the objective of investigation, the focus point will lie on the contractual relationship of stockholders (principal) and management (agent). Hence, a precise em­bodiment of this conflict will be outlined in the following section.

4.2.1 The Principal – Agent Conflict in Listed Companies

Within academic literature, a company is understood as an entity formed of contracts. Hence, the relationship of stakeholders towards and within the company is designed through conclusions of contracts which aim at the maximization of the principals’ wel-fare.⁷⁴ However, in reality it is not possible, for the principal and for the agent, to structure contracts in such a manner that they will result in zero costs and at the same time, will maximize the welfare of the principal.

Taking a corporate perspective, a possible contractual design could be established be­tween stockholders (principal) and management (agent). A basic model of the principal-agent-theory is therefore illustrated in figure 8.

Abbildung in dieser Leseprobe nicht enthalten

Figure 8: The standard model of the principal-agent conflict ⁷⁵

Due to the asymmetric distribution of information and, thus, incomplete contracts, three statements have to be made. First, shareholders of listed companies delegate their authority to dispose of their capital, to managers. The backdrop of this objective is to have sophisti­cated experts to manage the invested funds before the background of governance. Natu­rally, shareholders want their money being managed in their best interests. Depending on the proportion of their investment and on their investment horizon, shareholders are inter­ested in short term goals or an enhancement of long-run corporate value respectively.

Second, and contrary to the interest of shareholders, managers want a possibly high compensation for their efforts to enhance firm value. Depending on the design of their con-tracts, it is possible that the managing board does not act in the best interests of the share-holders.⁷⁶

It is also important to point out that Germany has a two tiered board model. This implies that the board of directors is more involved in the operational business activities than the supervisory board. Thus, the board of directors has an informational edge and is likely to exploit it. ⁷⁷

Subsequently, the principal-agent conflict does not only result from asymmetric distri­bution of information, as outlined above. In fact, the conflict arises from different objec­tives, both groups are pursuing. A summary of these different objectives of shareholders and managers is therefore illustrated in table 2.

Table 2: Objectives of the management vs. objectives of shareholders ⁷⁸

Abbildung in dieser Leseprobe nicht enthalten

Last but not least, there is one additional point which has to be stressed. The principal-agent conflict is more intense when a corporation is listed on the stock market and when the corporation is characterized by widely held stock ownership. This leads to a lack of control of the corporation and to almost ultimate power for the management. According to Nicolai and Thomas, this development is called “manager capitalism”.⁷⁹ To minimize these obvious disadvantages, it is necessary for investors to engage in this development. Hence, one possible solution for this problem can be found in activism.

[...]

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¹ See OECD (2004), p. 65.

² See Ben-Ur (2007), p. 2.

³ See Nicolai and Thomas (2004a), p. 20. Basically, this can be interpreted as the exercise of influence on corporate governance and corporate management.

⁴ This quotation can be translated as: the influence of investors on corporate governance and corporate management of listed companies. See Nicolai and Thomas (2004b), p. 453.

⁵ See Smith (1996), p. 227.

⁶ See Black (1997), p. 3.

⁷ See Becht et al. (2006), p. 3.

⁸ See §§ 118, 119 Stock Corporation Act (further AktG).

⁹ See Rappaport (1999), pp. 1 et seq.

¹⁰ See Gabler Wirtschaftslexikon (2004), p. 1597.

¹¹ See Wöhe and Bilstein (1991), p. 3.

¹² See Steiger (2000), p. 27.

¹³ See Deutsche Bundesbank (1998), p. 57.

¹⁴ See Deutsche Bundesbank (2001), p. 45.

¹⁵ See Ferreira and Matos (2007), p. 2.

¹⁶ See OECD (2003), p. 9.

¹⁷ See OECD (2004), p. 5.

¹⁸ See Schiereck (1995), pp. 7 et seq.

¹⁹ See Deutsche Bundesbank (1998), p. 56.

²⁰ See Deutsche Bundesbank (1997), p. 29.

²¹ See Hockmann and Thießen (2002), pp. 528 et seq.

²² See Deutsche Bank Research (2007), p. 3.

²³ See Europäische Union (1995), p. 11.

²⁴ See Shleifer and Vishny (1996), p. 2.

²⁵ See OECD (2004), p. 12.

²⁶ See Ringleb et al. (2003), p. 11.

²⁷ See OECD (2004), p. 11.

²⁸ See OECD (2004), p. 58.

²⁹ See OECD (2004), p. 11.

³⁰ See Grundsatzkommission Corporate Governance (2000a), p. 2.

³¹ See Steinmann and Schreyogg (2005), pp. 3 et seq.

³² See chapter 3.2.1 above.

³³ Unfortunately, data from the OECD ended at the end of 2001. As it seems not appropriate to use 7 year old data, I used data from Deutsche Bundesbank (2008), Gesamtverbandverband deutscher Versicherun-gen (GDV) (2007), Statistisches Bundesamt (2007).

³⁴ Own calculation and illustration. Source of data: Statistisches Bundesamt (2007), p. 623, Deutsche Bundesbank (2008a), p. 52, Deutsche Bundesbank (2008b), GDV (2007), p. 24.

³⁵ Own calculation and illustration. Source of data: Deutsche Bundesbank (2008a), p. 52, Deutsche Bundes­bank (2008b), GDV (2007), p. 24.

³⁶ The Compounded Annual Growth Rate (CAGR) is the year-over-year growth rate of a specified period of time and is mathematically defined as: CAGR= (Ending Value/Beginning Value)^(1/# of years)-1.

³⁷ Complementary to the statistics, it is noteworthy that these numbers only represent the holdings of banks and insurance companies respectively. Additionally, banks and insurance companies are also investors in investment funds and investment companies. Unfortunately, these numbers are not publicly available.

³⁸ See Deutsche Bundesbank (2008), pp. 52 et seq.

³⁹ See Ruser (2004), pp. 66 et seq.

⁴⁰ Since 2004 hedge funds are lawful in Germany. However, these hedge funds are subject to strong regula­tions and are allowed as „funds of funds“, only. In more detail, see Bahn (2006), p. 9.

⁴¹ See BVI (2008), p. 3.

⁴² See § 91 InvG.

⁴³ See Bassen (2002), p. 18.

⁴⁴ See BVI (2008), p. 8.

⁴⁵ See BVI (2008), p. 7.

⁴⁶ See chapter 4.1 above.

⁴⁷ To some extent, this is due to the fact that Germany’s capital markets were restricted and organized in the so called “German Inc.” However, this argument will be elaborated in more detail in chapter 4.1.2.

⁴⁸ See Deutsche Börse AG (2005a), website.

⁴⁹ See Deutsche Börse AG (2005b), website. See also Pierscinska, (2006), p. 49.

⁵⁰ See Admati/Pfleiderer (2007), p. 1.

⁵¹ See Admati/Pfleiderer (2005), p. 1.

⁵² See Stanford Encyclopaedia of Philosophy (2003), website.

⁵³ See Boehmer (1999), p. 1.

⁵⁴ See Deutsche Bundesbank (1997), p. 28.

⁵⁵ See Matthes (2000), pp. 30 et seq. and Witt (2003), p. 81.

⁵⁶ See Jürgens et al. (2000), p. 14 and Matthes (2000), p. 31. For example, reforms were introduced through the introduction of the Control and Transparency in Business Act (KonTraG, 01.05.1998), the German Transparency and Disclosure Act (TransPuG, 26.07.2002) as well as Finanzmarktfördergesetze.

⁵⁷ See Kengelbach and Roos (2006), p. 1.

⁵⁸ Own illustration but following Hoepner and Krempel (2003), p. 2.

⁵⁹ The market for corporate control is defined as equity transactions that are large enough to change corpo­rate control and, thus, affecting the efficiency of the firm and incentives to the managers.

⁶⁰ Own illustration but following Hoepner and Krempel (2003), p. 7.

⁶¹ See Kengelbach and Roos (2006), p. 12.

⁶² See Steiger (2000), p. 58. According to Steiger, concentrated ownership is characterized by long term stock holdings by (major) stockholders. In contrast, dispersed ownership is equity which is daily available for trading (free float).

⁶³ See Kengelbach and Roos (2006), p. 17. By contrast, only 15% of the quoted companies in the USA and the UK did have a controlling shareholder.

⁶⁴ See Gerke and Marger (2001), p. 551.

⁶⁵ See Steiger (2000), p. 27 as well as chapter 4.1.1 above.

⁶⁶ See Smith (1776/1974), p. 700.

⁶⁷ See Berle and Means (1932), pp. 244 et seq.

⁶⁸ See Shleifer and Vishny (1996), p. 7.

⁶⁹ See Jensen and Meckling (1976), p. 5.

⁷⁰ See Macharzina (2005), p. 63.

⁷¹ See Eisenhardt (1989), pp. 58 et seq.

⁷² See Jensen and Meckling (1976), p. 5. In this connection, Jensen and Meckling assume that both parties act as utility maximizer.

⁷³ See Jensen and Meckling (1976), pp. 5 et seq.

⁷⁴ See Jensen and Meckling (1976), p. 7.

⁷⁵ See Macharzina (2005), p. 64.

⁷⁶ See Hoensch et al. (2005), p. 13.

⁷⁷ See German Corporate Governance Code (2007), p. 1.

⁷⁸ See Macharzina (2005), p. 13.

⁷⁹ See Nicolai and Thomas (2004b), p. 452.