bps10 - understanding corporate governance

7/30/2019 BPS10 - Understanding Corporate Governance

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Governance

Knowledge objective

Understand corporate governance ...

as a system of ownership and stakeholder interests

as an agency problem in terms of TMT incentives

in relation to value creation

in terms of markets for corporate control

in relation to international


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Corporate GovernanceMechanisms

Ownership concentration

relative amounts of stock owned by

individual and institutional investorsBoard of Directors

individuals responsible forrepresenting the firms owners by

monitoring top-level managersstrategic decisions

Internal Governance Mechanisms


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Separation of Ownership and Control

Basis of the modern corporation shareholders purchase stock, becoming residual

claimantswho bear residual risk

shareholders reduce risk by holding diversifiedportfolios

professional managers are contracted to providedecision-making

Modern public corporation form leads toefficient specialization of tasks risk bearing by shareholders

strategy development and decision-making bymanagers


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Agency Theory

Basic Terms

Organizations: series of contractual relationshipsbetween agents and principals

Goal: efficient arrangement (lowest agency costs)

of agent-principal relationships.

Principals: owners (shareholders) of a firm

Agents:people hired by the owners to run thefirm (managers and workers)

Agency Costs: costs associated with monitoringagent behavior and enforcing contracts


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A specialist in risk-bearing (theprincipal) pays compensation to

A specialist in managerial decision-

making specialist (the agent)

Agency Relationship:Owners and Managers

AgencyRelationship

Managers(Agents)

Shareholders(Principals)

Decision makers

Firm owners


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Principal-Agent Theory

The heart of principal-agent theory is thetrade-off between

(a) the cost of measuring behavior and(b) the cost of measuring outcomes and

transferring risk to the agent.

Information is asymmetrically distributedbetween principals and agents

(Eisenhardt, 1989)


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Problem of Product DiversificationIncreased size, and the relationship ofsize to managerial compensationReduction of managerial employment

riskUse of Free Cash Flows

Managers prefer to invest these funds in

additional product diversification (seeabove).Shareholders prefer the funds as

dividends so they control how the fundsare invested.

Examples


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Agency Theory: Conflicts

Principals engage in monitoring behavior to assessthe activities and decisions of managers

But dispersed shareholding makes it difficult andinefficient to monitor managements behavior

Boards of Directors have a fiduciary duty toshareholders to monitor top management

However, Boards of Directors are often accused ofbeing lax in performing this function


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Agency Theory Problem

Problem: cost of measuring behavior

the desires or goals of the principal and agentconflict and it is difficult or expensive for the

principal to verify that the agent has behavedappropriately

Solution: Measure outcomes, transfer risk to theagent

principals create incentive-based performance

contracts principals monitor contract performance

(e.g., BOD)

Markey supply of managerial know-how (CEOs)

mitigate the agency problem


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Executive Compensation

use of salary, bonuses, and long-term

incentives to align managers interestswith shareholders interests

Monitoring by top-level managers

they may obtain Board seats (not in

financial institutions) they may elect Board representatives

Internal Governance Mechanisms


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Governance Mechanisms

ExecutiveCompensation

Stock ownership (long-termincentive compensation)

managers more susceptible tomarket changes which are partiallybeyond their control

Incentive systems do not

guarantee that managers make theright decisions, but do increasethe likelihood that managers will dothe things for which they arerewarded


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Manager and Shareholder Riskand Diversification

Risk

Diversification

Dominant

Business

Unrelated

Businesses

Related

Constrained

Related

Linked

Managerial

(employment)

risk profile

B

Shareholder

(business)

risk profileS

A

M


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Some research findings

Management controlled firms maximize CEO pay, s.t.legitimacy, externally controlled firms minimize CEOpay, s.t.CEO labor market (Hambrick & Finkelstein,1995)

Antitakeover defenses increase the premium for ahostile takeover by ~40%

Directors usually have only a nominal equity interestin the firm, but may receive substantial reputationalor monetary benefits from CEO nominations

Compensation consultants - accent performance-based incentives when results are good, and peer-based incentives when results are bad (Murphy,1999)

Stealth compensation ...


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Agency Problem exists elsewhere amongstakeholders, e.g., between shareholders and

debtholders

Debtholders often limit dividend payments(covenants) Why?

If the firm pays all excess cash to shareholders,there may not be enough left for debtholders.Dividends are a means that shareholders canuse to expropriate wealth from debtholders.

Agency Theory Conflicts


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Market for Corporate Control

the purchase of a firm that isunderperforming relative toindustry rivals in order toimprove its strategic

competitiveness

External Governance Mechanisms


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External Control

External control mechanisms:SEC, External auditors;Bondholders and lenders (banks);Financial analysts and credit rating agencies;Mergers and acquisitions;Institutional investors- pension funds, mutualfunds;

Stock prices;Labor markets.


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Governance MechanismsOwnership

Concentration Large block shareholders have a

strong incentive to monitormanagement closely

Their large stakes make it worththeir while to spend time, effortand expense to monitor closely

They may also obtain Board seats

which enhances their ability tomonitor effectively (althoughfinancial institutions are legallyforbidden from directly holding

board seats)


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Boards ofDirectors

Insiders The firms CEO and other top-

level managers

Related Outsiders Individuals not involved withday-to-day operations, but whohave a relationship with thecompany

Outsiders Individuals who are independent

of the firms day-to-dayoperations and other

relationships


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Boards of

Directors

Recommendations for moreeffective Board Governance:

Increase diversity of boardmembers backgrounds

Strengthen internalmanagement and accountingcontrol systems

Establish formal processes forevaluation of the boards

performance


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Executive

Compensation

Salary, bonuses, long termincentive compensation

Executive decisions are complexand non-routine

Many factors intervene making itdifficult to establish howmanagerial decisions are directlyresponsible for outcomes


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Market for

Corporate Control

Firms face the risk of takeoverwhen they are operatedinefficiently

Many firms begin to operate

more efficiently as a result ofthe threat of takeover, eventhough the actual incidence ofhostile takeovers is relativelysmall

Changes in regulations havemade hostile takeovers difficult

Acts as an important source ofdiscipline over managerialincompetence and waste


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International CorporateGovernance:

Owner and manager are often the same inprivate firms

Public firms often have a dominantshareholder, frequently a bank

Frequently there is less emphasis onshareholder value than in U.S. firms, although

this may be changing


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International Corporate Governance:

Medium to large firms have a two-tieredboard

vorstand monitors and controls managerialdecisions

aufsichtsrat selects the Vorstand

employees, union members and shareholdersappoint members to the Aufsichtsrat

Germany


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Obligation, family and consensus areimportant factors

Banks (especially main bank) are highlyinfluential with firms managers

Keiretsus are strongly interrelated groups offirms tied together by cross-shareholdings

Japan


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Other characteristics:

powerful government intervention

close relationships between firms and governmentsectors

passive and stable shareholders who exert littlecontrol

virtual absence of external market for corporatecontrol

Japan

bps10 - understanding corporate governance

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