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
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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 facilitate the achievement of strategic
competitiveness

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
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Separation of Ownership and

Managerial Control
Historically, firms were managed by founder-

owners and their 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 the
skills needed 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
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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 firms 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 firms owners
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Separation of Ownership and

Managerial Control
The separation between owners and managers also

creates an agency relationship

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 because
Shareholders lack direct control
Principals and agents have different interests and goals
Managerial opportunism: seeking self-interest with guile (i.e.,
cunning or deceit)
Principals dont know which agents will act opportunistically
Principals establish governance and control mechanisms to
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prevent agents from acting opportunistically

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
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Separation of Ownership and

Managerial Control
Agency problems: Firms 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
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Separation of Ownership and

Managerial Control
Agency costs and governance mechanisms

Agency Costs: Sum of all costs (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)
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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 corporations 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 firms choice of strategies and overall
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strategic direction

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 corporations
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
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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 firms day-to-day operations
Related Outsider
Directors who have some relationships with the firm
Their independence is questionable
Not involved with the corporations day-to-day activities
Outsider
Directors that provide independent counsel to the firm
May hold top-level managerial positions in other
companies
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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.
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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 boards 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
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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

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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 toplevel managers make is difficult to evaluate
Decisions affect financial outcomes over an extended period
External factors can also affect a firms 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

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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

Need (for external mechanisms) exists to

Becomes active when a firms internal controls fail

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
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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
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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

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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
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