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Corporate Governance

Corporate Governance. Corporate governance is a relationship among stakeholders that is used to determine and control the strategic direction and performance of organizations concerned with identifying ways to ensure that strategic decisions are made effectively

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Corporate Governance

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  1. Corporate Governance • Corporate governance is • a relationship among stakeholders that is used to determine and control the strategic direction and performance of organizations • concerned with identifying ways to ensure that strategic decisions are made effectively • used in corporations to establish order between the firm’s owners and its top-level managers

  2. Corporate Governance Mechanisms Board of Directors Internal Governance Mechanisms Managerial Incentive Compensation Ownership Concentration External Governance Mechanisms Market for Corporate Control

  3. Separation of Ownership and Managerial Control • Basis of the modern corporation • shareholders purchase stock, becoming residual claimants • shareholders reduce risk by holding diversified portfolios • professional managers are contracted to provide decision-making • Modern public corporation form leads to efficient specialization of tasks • risk bearing by shareholders • strategy development and decision-making by managers

  4. Shareholders (Principals) Agency Relationship: Owners and Managers • Firm owners

  5. Managers (Agents) Shareholders (Principals) Agency Relationship: Owners and Managers • Firm owners • Decision makers

  6. An Agency Relationship Managers (Agents) Shareholders (Principals) Agency Relationship: Owners and Managers • Firm owners • Decision makers • Risk bearing specialist (principal) pays compensation to a managerial decision-making specialist (agent)

  7. Agency Theory Problem • The agency problem occurs when: • the desires or goals of the principal and agent conflict and it is difficult or expensive for the principal to verify that the agent has behaved inappropriately • Solution: • principals engage in incentive-based performance contracts • monitoring mechanisms such as the board of directors • enforcement mechanisms such as the managerial labor market to mitigate the agency problem

  8. S M A B Manager and Shareholder Risk and Diversification Shareholder (business) risk profile Managerial (employment) risk profile Risk Dominant Business Related Constrained Related Linked Unrelated Businesses Diversification

  9. Board of Directors Governance Mechanisms • Insiders • The firm’s CEO and other top-level managers • Affiliated Outsiders • Individuals not involved with day-to-day operations, but who have a relationship with the company • Independent Outsiders • Individuals who are independent of the firm’s day-to-day operations and other relationships

  10. Board of Directors Governance Mechanisms • Role of the Board of Directors • Monitor – Are managers acting in shareholders best interests • Evaluate & Influence – examine proposals, decisions actions, provide feedback and offer direction • Initiate & Determine – delineate corporate mission, specify strategic options, make decisions

  11. Board of Directors Executive Compensation Governance Mechanisms • Salary, bonuses, long term incentive compensation • Executive decisions are complex and non-routine • Many factors intervene making it difficult to establish how managerial decisions are directly responsible for outcomes

  12. Board of Directors Executive Compensation Governance Mechanisms • Stock ownership (long-term incentive compensation) makes managers more susceptible to market changes which are partially beyond their control • Incentive systems do not guarantee that managers make the “right” decisions, but do increase the likelihood that managers will do the things for which they are rewarded

  13. CEO Pay and Performance • Classic pay for • performance • relationship • Unfortunately, this • relationship is weak CEO Pay • The stronger • relationship is with • firm size Firm Performance

  14. CEO Pay and Firm Size • Relationship between pay and firm size is curvilinear. • CEO pay increases at • a decreasing rate CEO Pay Firm Size

  15. Relationship Between Firm performance and Firm Size • Relationship between firm performance and firm size is curvilinear. • Beyond some point, as • size increases, firm • performance declines Firm Performance • BUT… • From the graph of CEO • pay vs. firm size, pay • doesn’t decline Firm Size

  16. Relationship Between Firm performance and Equity Ownership • Relationship between firm performance (Tobin’s Q) and managerial ownership is curvilinear. Firm Value • Beyond some point, as • ownership increases, • firm value declines Managerial Ownership in %

  17. Ownership Concentration Board of Directors Executive Compensation Governance Mechanisms • Large block shareholders (often institutional owners) have a strong incentive to monitor management closely • Exit vs. Voice – Cannot costlessly exit due to equity stake (transaction costs) so they press for change (exercise voice) • They may also obtain Board seats which enhances their ability to monitor effectively (although financial institutions are legally forbidden from directly holding board seats)

  18. Ownership Concentration Board of Directors Executive Compensation Governance Mechanisms • Types of institutional investors • - Mutual funds, pension funds, • foundations, churches, universities, • insurance companies • Pressure-resistant versus pressure-sensitive • - Mutual and pension funds are • pressure resistant • Are Institutional investors the same? • - Short vs. long term • Components of voice: • - Pension fund hit lists • - Shareholder liability suits • - Investor alliances • - Proxy contests

  19. Ownership Concentration Board of Directors Executive Compensation Market for Corporate Control Governance Mechanisms • Firms face the risk of takeover when they are operated inefficiently • Many firms begin to operate more efficiently as a result of the “threat” of takeover, even though the actual incidence of hostile takeovers is relatively small • Changes in regulations have made hostile takeovers difficult • Acts as an important source of discipline over managerial incompetence and waste

  20. Managerial Defense Tactics • Designed to fend off the takeover attempt • Increase the costs of making the acquisitions • Causes incumbent management to become entrenched while reducing the chances of introducing a new management team • May require asset restructuring • Institutional investors oppose the use of defense tactics

  21. Financial Mechanisms Takeover Defenses: • Poison pills • Leveraged recapitalizations • Greenmail • Litigation

  22. Asset-Based Mechanisms Financial Mechanisms Takeover Defenses: • Poison pills • Leveraged recapitalizations • Greenmail • Litigation • Scorched earth defense • Crown jewel sales • Pac-man defense

  23. Third Party Mechanisms Asset-Based Mechanisms Financial Mechanisms Takeover Defenses: • Poison pills • Leveraged recapitalizations • Greenmail • Litigation • Scorched earth defense • Crown jewel sales • Pac-man defense • White knight defense • Other bidder (competitive bid situation)

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