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Prepared by: Enrique, Lihong, John, Jongkuk

On the Efficiency of Internal and External Corporate Control Mechanisms Walsh, James P. and Seward, James K. (1990), Academy of Management Review , 15 (3): 421-458. Prepared by: Enrique, Lihong, John, Jongkuk. Introduction.

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Prepared by: Enrique, Lihong, John, Jongkuk

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  1. On the Efficiency of Internal and External Corporate Control MechanismsWalsh, James P. and Seward, James K. (1990), Academy of Management Review, 15 (3): 421-458 Prepared by: Enrique, Lihong, John, Jongkuk

  2. Introduction • In modern firms, owners usually diversify their holdings: • Owners usually do not monitor managers themselves • Boards of Directors are hired to monitor the managers for the owners • As the amount of influence of individual shareholders decrease, the influence of top management increases

  3. Owner’s Interests • To earn the maximum economic profit with a compatible degree of risk • To distribute the profits generously and equitably among the owners • To maintain market conditions favorable to the owner (Berle & Means, 1932)

  4. Manager’s Interests • Unfortunately the management may be motivated by: • Prestige • Power • Gratification of professional zeal • This is the “agency problem”

  5. Internal Control Options • These are measures designed to bring the economic interests of managers and shareholders into alignment • Managerial vs. Environmental Assessments must be made: • Bad decisions • Unfavorable business environment

  6. Assessment • How does the board assess the situation? • From inside directors • By comparing with other similar firms • Managers can become the scapegoats for poor performance

  7. Misplaced Misguided High Figure 1: Inferences about top Management Performance Effort Incompetent Shirking Low Low High Ability

  8. Internal Control Options • Alter the incentives of top management • Are the incentives structured correctly? • Increasing the magnitude of compensation • Tying compensation to firm results • Accounting rates of return • Use market measures like stock price • Dismiss top management

  9. Internal Entrenchment Practices • Alter personal assessments of the board • Withholding information • Using outside consulting reports • Set norms where they cannot be questioned • Alter Situation Assessments • Pointing out the environmental difficulties

  10. Internal Entrenchment Practices • Alter Performance Assessments • Set low expectations • Redefine performance metrics • Avoid Internal Control Mechanisms • Avoid pay-for-performance plans • Aim for high management salaries • Use accounting measures for bonuses • Become non-substitutable (Lee Iacocca)

  11. Addressing Internal Control Inefficiencies • Include outside directors on the board • Increase the ownership of managers • May increase manager entrenchment • May also align managers and owners

  12. External Control Options • The Market for Corporate Control • Assumptions: • Underperformance will be represented in company stock • Other management teams will compete for the company’s resources • The firm will be acquired

  13. Reasons to Acquire a Firm • Reasons to Acquire • Synergies • Tax Savings • Wealth transfers • Hubris • Elimination of inefficient management • Target firms usually increase in value

  14. Operating Non-Operating Dual Class Re-capitalization Supermajority amendments Fair Price amendments State of incorporation Voting Rights amendments Shareholder Approval Required Acquisitions and divestitures Greenmail Poison Pills New Securities Spin offs, Sell offs etc. Litigation by target Standstill Agreements Anti-takeover amendments Golden Parachutes No Shareholder Approval Required

  15. Management Good Bad Effective Governance Internal: Incentives are designed appropriately and management responds appropriately External: None needed Managerial Deadwood Internal: Incentives are designed appropriately and management responds inappropriately External: Tender Offers Good Board of Directors Board Obstruction Internal: Incentives are designed inappropriately and management is scapegoated External: Going private Governance Failure Internal: Incentives are designed inappropriately and management exhibits low ability and effort External: hostile takeovers Bad

  16. International Perspectives • Different countries use different mechanisms • I.E., Japan generally does not use turnover as a control mechanism • Monitoring often comes from banks and capital sources

  17. Conclusions • Both internal and external controls are used by firms to control managers • Management can use various methods to entrench themselves against these controls • Work by financial economists and organizational theorists can be synthesized

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