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Chapter 10: Corporate Governance (CG)

Overview: Define corporate governance and describe its purpose Separation between ownership and management control Agency relationship and managerial opportunism Three internal governance mechanisms used to

monitor/control management decisions The external market for corporate control Use of external corporate governance in international

settings How corporate governance can foster ethical strategic

decisions

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The Strategic Management Process

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Introduction

Corporate Governance (CG): The set of mechanisms used to manage the relationship among stakeholders and to determine and control the strategic direction and performance of organizations Concerned with identifying ways to ensure that strategic decisions

are made effectively and facilitate the achievement of strategic competitiveness

Primary objective: align the interests of managers and shareholders Recent corporate scandals (Enron, Tyco, Arthur Anderson) largely

a result of poor corporate governance Involves oversight in areas where the interests of owners,

managers, and members of the board conflict Top-level managers are expected to make decisions that

maximize company value and owner wealth Effective governance can lead to a competitive advantage

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Separation of Ownership and Managerial Control

Historically, firms were managed by founder-owners and their descendants Ownership and control resided in the same persons Over time these firms faced two critical issues

As they grew, they did not have access to all the skills needed to manage the growing firm and maximize its returns, so they needed outsiders to improve management

They also needed to seek outside capital (whereby they give up some ownership control)

Firm growth lead to the separation of ownership and control in most large corporations

This resulted in the Modern Public Corporation

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Separation of Ownership and Managerial Control

The Modern Public Corporation is based on the efficient separation of ownership and managerial control This separation allows shareholders to purchase stock, giving

them an ownership stake and entitling them to income (residual returns) after expenses

This right implies a ‘risk’ for shareholders that expenses may exceed revenues

This risk is managed through a diversified investment portfolio Shareholder value is thus reflected in the price of the firm’s stock

Shareholders specialize in risk bearing while managers specialize in decision making

The separation and specialization of ownership and managerial control should produce the highest returns for the firm’s owners

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Separation of Ownership and Managerial Control

The separation between owners and managers also creates an agency relationship

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Separation of Ownership and Managerial Control

Agency Relationship – exists when one or more persons (principals) hire another person or persons (agents) as decision-making specialists to perform a service

Decision making responsibility is delegated to a second party for compensation

Agents manage principals' operations and maximize their returns Can lead to agency problems because

Shareholders lack direct control Principals and agents have different interests and goals Managerial opportunism: seeking self-interest with guile (i.e.,

cunning or deceit) Principals don’t know which agents will act opportunistically

Principals establish governance and control mechanisms to prevent agents from acting opportunistically

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Separation of Ownership and Managerial Control

Agency problems: Product diversification Product diversification can result in 2 managerial

benefits that shareholders do not enjoy: Increases in firm size is positively related to executive

compensation (firm is more complex and harder to manage) Firm portfolio diversification can reduce top executives’

employment risk (i.e., job loss, loss of compensation and loss of managerial reputation)

Diversification reduces these risks because a firm and its managers are less vulnerable to the reduction in demand associated with a single or limited number of product lines or businesses

Top managers prefer product diversification more than shareholders do

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Separation of Ownership and Managerial Control

Agency problems: Firm’s free cash flow Resources remaining after the firm has invested in all

projects that have positive net present values within its current businesses

Available cash flows Managerial inclination to overdiversify can be acted upon

Self-serving and opportunistic behavior Shareholders may prefer distribution as dividends so they can

control how the cash is invested Figure 10.2

Curve S depicts the optimal level of diversification where Point A is preferred by shareholders and Point B by top managers

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Manager and Shareholder Risk and Diversification

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Separation of Ownership and Managerial Control

Agency costs and governance mechanisms Agency Costs: Sum of all costs (incentive costs, monitoring costs,

enforcement costs) and individual financial losses incurred by principals because governance mechanisms cannot guarantee total compliance by the agent

There are costs associated with agency relationships – principals incur costs to control their agents’ behaviors

Effective governance mechanisms should be employed to improve managerial decision making and strategic effectiveness

Governance mechanisms: used to control managerial behavior – to make sure they are acting in the best interest of shareholders

Governance mechanisms are costly Includes internal mechanisms (ownership concentration, board of

directors, and executive compensation) and external mechanisms (market for corporate control)

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Governance Mechanisms: Ownership Concentration

Ownership Concentration: Governance mechanism defined by both the number of large-block shareholders and the total percentage of shares they own Large Block Shareholders: Shareholders owning at

least 5 percent of a corporation’s issued shares Diffuse ownership produces weak monitoring of managers’

decisions and makes it difficult for owners to effectively coordinate their actions

Institutional Owners: Financial institutions such as stock mutual funds and pension funds that control large-block shareholder positions

Own over 50% of the stock in large U.S. corporations Have the size and incentive to discipline ineffective managers

and can influence firm’s choice of strategies and overall strategic direction

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Governance Mechanisms: The Board of Directors (BOD)

Board of Directors: A group of shareholder-elected individuals whose primary responsibility is to act in the owners’ interests by formally monitoring and controlling the corporation’s top-level managers

An effective and well-structured board of directors can influence the performance of a firm

Boards are responsible for overseeing managers to ensure the company is operated in ways to maximize shareholder wealth

Boards have the power to: Direct the affairs of the organization Punish and reward managers Protect shareholders’ rights and interests Protect owners from managerial opportunism

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Governance Mechanisms: The Board of Directors (BOD)

3 Groups of Directors/Board Members: Insider

Active top-level managers in the corporation Elected to the board because they are a source of

information about the firm’s day-to-day operations Related Outsider

Directors who have some relationships with the firm Their independence is questionable Not involved with the corporation’s day-to-day activities

Outsider Directors that provide independent counsel to the firm May hold top-level managerial positions in other

companies

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Governance Mechanisms: The Board of Directors (BOD)

Historically, BOD dominated by inside managers Provided relatively weak monitoring and control of managerial

decisions Movement is towards greater use of independent outside

directors Becoming significant majority on boards Chairing compensation, nomination, and audit committees Improve weak managerial monitoring and control that corresponds

to inside directors Large number of outsiders can create problems though

Tend to emphasize financial (vs. strategic) controls They do not have access to daily operations and a high level of

information about managers and strategy Can result in ineffective assessments of managerial decisions and

initiatives.

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Governance Mechanisms: The Board of Directors (BOD)

Enhancing BOD effectiveness (actual trends) Increased diversity in board members’ backgrounds Strengthening of internal management and accounting

control systems Establishment and consistent use of formal processes

to evaluate the board’s performance Creation of a “lead director” role that has strong

agenda-setting and oversight powers Modification of the compensation of directors Require that outside directors own significant equity

stakes in the company in order to keep focused on shareholder interests

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Governance Mechanisms: Executive Compensation

Executive compensation: Governance mechanism that seeks to align the interests of top managers and owners through salaries, bonuses, and long-term incentive compensation, such as stock awards and stock options Critical part of compensation packages in U.S. firms Alignment of pay and firm performance can help

company avoid agency problems by linking managerial wealth with shareholder wealth

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Governance Mechanisms: Executive Compensation (EC)

The effectiveness of executive compensation Is complicated, especially long-term incentive compensation

The quality of complex and nonroutine strategic decisions that top-level managers make is difficult to evaluate

Decisions affect financial outcomes over an extended period External factors can also affect a firm’s performance

Performance-based compensation plans are imperfect in their ability to monitor and control managers

Incentive-based compensation plans intended to increase firm value in line with shareholder expectations can be subject to managerial manipulation to maximize managerial interests

Many plans seemingly designed to maximize manager wealth rather than guarantee a high stock price that aligns the interests of managers and shareholders

Stock options are highly popular but can also be manipulated

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Governance Mechanisms: Market for Corporate Control

Market for Corporate Control: external governance mechanism consisting of a set of potential owners seeking to acquire undervalued firms and earn above-average returns on their investments

Becomes active when a firm’s internal controls fail Need (for external mechanisms) exists to

address weak internal corporate governance correct suboptimal performance relative to competitors, and discipline ineffective or opportunistic managers.

External mechanisms are less precise than internal governance mechanisms

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Governance Mechanisms: Market for Corporate Control

Hostile takeovers are the major activity in the market for corporate control Not always due to poor performance

Managerial defense tactics Used to reduce the influence of this governance mechanism Hostile takeover defense strategies include

Poison pill Corporate charter amendment Golden parachute Litigation Greenmail Standstill agreement Capital structure change

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International Corporate Governance

Global Corporate Governance Governance systems differ across countries Important to understand these differences if you

are competing internationally Trend is toward relatively uniform governance

structures across countries These structures are moving closer to the U.S.

corporate governance model

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Governance Mechanisms and Ethical Behavior

It is important to serve the interests of all stakeholder groups

In the U.S., shareholders (capital market stakeholders) are the most important stakeholder group served by the board of directors

Governance mechanisms focus on control of managerial decisions to protect shareholders’ interests

Product market stakeholders (customers, suppliers and host communities) and organizational stakeholders (managerial and non-managerial employees) are also important stakeholder groups

Important to maintain ethical behavior through governance mechanisms