Download - 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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Corporate GovernanceMechanisms
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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Corporate GovernanceMechanisms
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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Governance Mechanisms
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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Governance Mechanisms
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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Governance Mechanisms
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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Governance Mechanisms
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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International Corporate Governance:
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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International Corporate Governance:
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