Lecture 10 Corporate Governance

Objectives

1. Introduce corporate governance (separation of ownership, managerial opportunism).

2. Explain three internal governance mechanisms (ownership concentration, the board of directors and executive compensation).

3. Describe external corporate governance mechanism - the market for corporate control.

4. Discuss corporate governance in international settings.

5. Ethical issues.

In 1990s, CEOs worth more than their weight in gold: Michael Eisner, CEO of Disney ($631 million), Stephen Case, CEO of America Online ($220 million), Jack Welch, CEO of GE ($164 million), Carly Fiorina, CEO of HP ($80-90 million).

In 2006 a record number of CEOs left their jobs through dismissal, retirement or recruitment to another firm.

All of this scrutiny may have a price:

Average tenure 18-24 months.

“At the current rate, almost 50 percent of the largest U.S. firms will have a new CEO in next four years” Harvard Business Review.

Trends in recent corporate governance.

What is Corporate Governance

Define corporate governance.

Shareholders

Employees

Managers

Main company Board(e.g. chairman’s, audit, remuneration, nomination)

The way in which organisations are directed and controlled. (Cadbury 1992)

The Primary objective: ensure that the interests of top-level managers are aligned with the interests of the shareholders

Stakeholders(e.g. suppliers, consumers, local communities)

• Banks• Mutual funds• Insurance companies• Pension funds – largest pool of money in the world•Hedge funds

Separation of ownership and managerial control

Small firms- simplest, an owner-manager Large firms are usually more complicated

Shareholders (principles)•Firm owners

Managers (Agents)•Decision makers

An agency relationship• Risk-bearing specialists (principle) Paying compensation to• A managerial decision–making specialist (agent)

Hire

and create

Managerial opportunism: the seeking of self-interest with guile.

• Product diversification

The size of the firm.

The portfolio of the businesses.

The firm’s free cash flows.

An agency relationship and managerial opportunism

Ris

kR

isk

Level of DiversificationLevel of Diversification

Manager and Shareholder Risk and DiversificationManager and Shareholder Risk and Diversification

DominantBusiness

DominantBusiness

UnrelatedBusinessesUnrelatedBusinesses

RelatedConstrained

RelatedConstrained

RelatedLinkedRelatedLinked

Shareholder Shareholder (Business) (Business)

Risk ProfileRisk Profile

ManagerialManagerial(Employment) (Employment)

Risk ProfileRisk ProfileSS

MM

AABB

Enron: The seventh largest company in USA. The collapse of Enron wiped out

shareholders investment (£60bn) and employee’s retirement saving, and led to 21,000 people losing their jobs.

Filed bankruptcy in December 2001 with debts of £18bn. In September 2006, Andrew Fastow, the former CFO was jailed for six

years.

WorldCom: America's second-biggest long-distance phone company and the

largest mover of internet traffic. WorldCom reported more than $107bn (£67.9bn) in assets and

debts of $32bn. Bernie Ebbers, the chief executive officer engaged an $11 billion

accounting fraud received a 25 years prison

Corporate governance Mechanism

Internal Governance mechanisms

• Ownership concentration

• Board of directors

• Executive compensation

External governance mechanism

• Market for corporate control

Agency costs: the sum of incentive costs, monitoring costs, enforcement costs, and individual financial loses incurred by principles because governance mechanisms can not guarantee total compliance by the agent.

Ownership concentration: relative amounts of stock owned by individual shareholders and institutional investors Ownership concentration in firms and with levels of product

diversification. Concentration with firm value

The growing influence of institutional owners• Institutional owners: financial institutions such as stock

mutual funds and pension funds.

Board of directors: a group of elected individuals whose primary responsibility is to act in the owners’ best interests by formally monitoring and controlling the corporation’s top-level executives.

Classifications of board of director members

Insiders

• The firm’s CEO and other top-level managers

Related outsiders

• Individuals not involved with the firm’s day-to-day operations, but who have a relationship with the company

Outsiders

• Individuals who are independent of the firm in terms of day-to-day operations and other relationships

Today’ typical board

Size

Insider/outsider mix

Meeting frequency/committees

Enhancing the effectiveness of the Board of Directors

1) Increases in the diversity of the background of board members.

2) The strengthening of internal management and accounting control systems.

3) The establishment and consistent use of formal processes to evaluate the board’s performance.

Additional changes

4) The creation of a ‘lead director’

5) Modification of the compensation of directors

Executive compensation

Executive compensation:

Short term incentive:

1. Salary – Cash

2. The guaranteed bonuses

3. Deliberate obfuscation

4. Loans

5. Golden hello (W.James, a pay package of $52 million, including $25.3 million of restricted shares and $22 million from Boeing to replace his 3M pension)

Executive compensation Long term Executive compensation:

1. Stock options: the right to purchase a block of the company’s stock at some specified point in the future at a ‘strike price’ set at the time of award, often the current trading price.

‘The company’s stock option programme is designed to focus attention on stock values, and to develop company ownership, promote employee loyalty, reward long-term business success and develop a parallel interest between key employees and shareholders’ A typical description of a stock option plan

Re-pricing Backdating (picked the date in the past with the lowest stock price,

making he grants automatically ‘in the money’); spring loading options (setting an option grant date just before an

announcement of good news), and bullet-dodging (setting an option grant date just after an

announcement of bad news)

Executive compensation

2. Restricted stock: awarded stock with limits on its transferability for a set time, normally 2-3 years. Very popular in a down market.

3. Phony cuts (Steve Jobs returned to Apple in 1997, who took $1 a year in compensation. In Jan.2000, Apple’ board gave Jobs an option grant covering 20 million shares ($43.59 a share; $471 million); But the stock fell, and so the board give Jobs another option grant in 2001 – 7.5 million shares ($18.30). The stock fell to £14.91, the board gave him 5 million free shares. And the original option grants had all been backdated.)

Executive compensationBut long term incentive compensation is complicated for:

Executive decisions are complex and non-routine.

Many factors intervene making it difficult to establish how managerial decisions are directly responsible for outcomes.

In addition, 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 Incentive systems do not guarantee that managers make the “right” decisions, but they do increase the likelihood the “right” decisions, but they do increase the likelihood that managers will do the things for which they are that managers will do the things for which they are rewarded.rewarded.

The market for corporate control acts as an important source of The market for corporate control acts as an important source of discipline over managerial incompetence and waste.discipline over managerial incompetence and waste.

Market for corporate control: an external governance mechanism that becomes active when a firm’s internal controls fail. “court of last resort” .

The 1980s saw active market for corporate control, largely as a result of available pools of capital (junk bonds).

Many firms began to operate more efficiently as a result of the “threat” of takeover, even though the actual incidence of hostile takeovers was relatively small.

Changes in regulations have made hostile takeovers difficult.

Takeover attempts were focused on above-average performance firms (e.g. the hedge funds)

Managerial defence tactics

Preventative tacticsPreventative tactics

1. Poison pill: preferred stock in the merged firm offered to shareholders at a highly attractive rate of exchange;

Flip-in options

Flip-over rights

2. Corporate charter amendment: an amendment to stagger the elections of members to the board of directors of the target firm so that all are not elected during the same year, which prevents a bidder from installing a completely new board in the same year.

3. Golden Parachutes: Lump-sum payments of cash that are distributed to a selected group of senior executives when the firm is acquired in a takeover bid;

Reactive tacticsReactive tactics1. Greenmail: the repurchase of shares of stock that have been

acquired by the aggressor at a premium in exchange for an agreement that the aggressor will no longer target the company for a target. (e.g. Bass Brothers and Texaco)

2. Standstill agreement: contract between the parties in which the pursuer agrees not to acquire any more stock of the target firm for a specified period of time in exchange for the firm paying the pursuer a fee. (e.g. Comcast and AT&T Broadband)

3. Capital structure change: dilution of stock - making it more costly for a bidder to acquire (may include recapitalisation e.g. issuing employee stock ownership, selling additional shares and share buybacks).

Hostile takeover defense tactics Defence strategy

Category Popularity among firms

Effectiveness as a defense

Poison pill(flip over and flip in)

preventive high high

Corporate charter amendment

preventive medium low

Golden parachutes

preventive medium low

Greenmail reactive very low medium

Standstill agreements

reactive low low

Capital structure changes

reactive medium medium

Owner and manager are often the same in private firmsOwner and manager are often the same in private firms

Public firms often have a dominant shareholder too, frequently a bankPublic firms often have a dominant shareholder too, frequently a bank

Medium to large firms have a two-tiered boardMedium to large firms have a two-tiered board

Vorstand (management board) monitors and controls managerial decisions

Aufsichtsrat (supervisory board) selects the Vorstand

Employees, union members and shareholders appoint members to the Aufsichtsrat

Frequently there is less emphasis on shareholder value than in U.S. Frequently there is less emphasis on shareholder value than in U.S. firms, although this may be changing.firms, although this may be changing.

International corporate governance:GermanyGermany

International corporate governance:JapanJapan

Obligation, “family” and consensus are important factors.

Banks (especially “main bank”) are highly influential with firm’s managers.

Keiretsus are strongly interrelated groups of firms tied together by cross-shareholdings.

Other characteristics:

Powerful government intervention.

Close relationships between firms and government sectors.

Passive and stable shareholders who exert little control.

Virtual absence of external market for corporate control.

Confucianism which has dominated Chinese social ideology for over 2000 years.

Incentives within the State Structures of Control:

Political status

Financial rewards

Informal opportunities for gain

Banks and stock markets are major sources for SOEs.

International corporate governance:ChinaChina

Business ethics in corporate strategy – 1

Business ethics are the standards and conduct that an organisation sets itself in its dealings within the organisation and outside its environment.

These need to be reflected in the mission statement.

Business ethics in corporate strategy – 2

There are four main reasons for considering the ethical conduct of organisations:

To some extent, inescapable, e.g. legal limits on conduct.

Some areas may be important: e.g. ‘green’ issues.

Part of the professionalization of business, e.g. treatment of workers.

Self-interest, e.g. bad publicity as a result of incorrect behaviour.

Three prime considerations in developing business ethics:

1. extent of ethical considerations

2. their cost and

3. the recipient of the responsibility.

Numerous differences exist between organisations over what should be covered under ethics, reflecting fundamentally different approaches to doing business.

Business ethics in corporate strategy – 3

Summary Corporate governance is a relationship among stakeholders

that is used to determine a firm’s direction and control its performance. How firm monitor and control top-level managers’ decisions and actions affects the implementation of strategies.

Effective governance that aligns managers’ decisions with shareholders’ interests can help produce a competitive advantage.

Separation of ownership and control create an agency problem when an agent pursues goals that conflict with principals’ goals.

Principles establish and use governance mechanisms to control this problem (internal: ownership concentration, the board of directors and executive compensation; one external: takeover)

Reading lists

Deutsch, Y., Kei, K. & Laamanen, T. 2007, Decision making in acquisitions: the effect of outside director’s compensation on acquisation patterns, Journal of Management, 33 (1): 30-56.

Faleye, O. 2007, Classified boards, firm value and managerial entrenchment, Journal of Financial Economics, 83: 501-529

Henry, A. (2008) Understanding Strategic Management, Oxford Press, chapter 8.

Pearce, J. A. and Robinson, R.B. 2004, Hostile takeover defenses that maximize shareholder wealth, Business Horizons 47/5 September-October, 15-24.

Kirvogorsky, V. 2006, Ownership, board structure and performance in continental Europe, International Journal of Accounting, 41 2: 176-179.

Lynch R. (2008) Corporate Strategy, Prentice Hall, 5th edition, chapter 6.