Chapter 10: Corporate Governance (CG)

1. 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

2. The Strategic Management Process

3. 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 align with company values • 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

4. Separation of Ownership and Managerial Control • Historically, firms were managed by founder-owners & 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 needed skills 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

5. 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

6. Separation of Ownership and Managerial Control • The separation between owners and managers creates an agency relationship

7. 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 • Shareholders lack direct control • Principal and agent 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

8. 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

9. 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

10. Manager and Shareholder Risk and Diversification

11. Separation of Ownership and Managerial Control • Agency costs and governance mechanisms • Agency Costs: Sum of 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)

12. 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

13. 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

14. 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

15. 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.

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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