BUSI 4940 Chapter 10 (Textbook)

institutional activism has the potential to

discipline managers and to enhance the likelihood of a firm taking future actions that are not only in shareholders' best interests but also those of all stakeholders including society at large.

what is a primary objective of corporate governance

ensuring that top-level managers' interests are aligned with other stakeholders' interests, particularly those of shareholders -Thus, corporate governance involves oversight in areas where owners, managers, and members of boards of directors may have conflicts of interest

Because the market for corporate control tends to increase risk for managers, managerial pay may be augmented indirectly through

golden parachutes

Related outsiders

have some relationship with the firm, contractual or otherwise, that may create questions about their independence, but these individuals are not involved with the corporation's day-to-day activities.

mergers and acquisitions are

highly complex strategic actions with many purposes and potential outcomes. -some are successful and many are not—even when they have potential to do well—because implementation challenges when integrating two diverse firms can limit their ability to realize their potential

Summary 1

Corporate governance is a relationship among stakeholders that is used to determine a firm's direction and control its performance. How firms 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 for the firm.

Summary 10

Effective governance mechanisms ensure that the interests of all stakeholders are served. Thus, strategic competitiveness results when firms are governed in ways that permit at least minimal satisfaction of capital market stakeholders (e.g., shareholders), product market stakeholders (e.g., customers and suppliers), and organizational stakeholders (e.g., managerial and non-managerial employees). Moreover, effective governance produces ethical behavior in the formulation and implementation of strategies.

Summary 7

Executive compensation is a highly visible and often criticized governance mechanism. Salary, bonuses, and long-term incentives are used for the purpose of aligning managers' and shareholders' interests. A firm's board of directors is responsible for determining the effectiveness of the firm's executive compensation system. An effective system results in managerial decisions that are in shareholders' best interests.

Because of their relatively ineffective performance and in light of the recent financial crisis, boards are experiencing

increasing pressure from shareholders, lawmakers, and regulators to become more forceful in their oversight role to prevent top-level managers from acting in their own best interests. -Moreover, in addition to their monitoring role, board members increasingly are expected to provide resources to the firms they serve. These resources include their personal knowledge and expertise and their relationships with a wide variety of organizations

executive compensation

is a governance mechanism that seeks to align the interests of managers and owners through salaries, bonuses, and long-term incentives such as stock awards and options.

The board of directors

is a group of elected individuals whose primary responsibility is to act in the owners' best interests by formally monitoring and controlling the firm's top-level managers

A hostile takeover

is an acquisition of a target company by an acquiring firm that is accomplished "not by coming to an agreement with the target company's management but by going directly to the company's shareholders or fighting to replace management in order to get the acquisition approved.

Outsiders

provide independent counsel to the firm and may hold top-level managerial positions in other companies or may have been elected to the board prior to the beginning of the current CEO's tenure -Individuals who are independent of the firm in terms of day-to-day operations and other relationships

top-level managers—as agents—also seek an optimal level of diversification

Declining performance resulting from too much diversification increases the probability that external investors (representing the market for corporate control) will purchase a substantial percentage of or the entire firm for the purpose of controlling it

Summary 2

Three internal governance mechanisms are used in the modern corporation: -ownership concentration -the board of directors -executive compensation The market for corporate control is an external governance mechanism influencing managers' decisions and the outcomes resulting from them.

When designed properly and used effectively, each of the three internal governance mechanisms can

contribute positively to the firm operating in ways that best serve stakeholders and especially shareholders' interests. By the same token, because none of the three mechanisms are perfect in design or execution, the market for corporate control, an external governance mechanism, is sometimes needed.

product diversification can

create two benefits for top-level managers that shareholders do not enjoy, meaning that they may prefer product diversification more than shareholders do 1. it usually increases the size of a firm and size is positively related to executive compensation 2. can reduce top-level managers' employment risk. Managerial employment risk is the risk of job loss, loss of compensation, and loss of managerial reputation.* These risks are reduced with increased diversification because a firm and its upper-level managers are less vulnerable to the reduction in demand associated with a single or limited number of product lines or businesses

different nations do have

different governance systems in place. Recognizing and understanding differences in various countries' governance systems, as well as changes taking place within those systems, improves the likelihood a firm will be able to compete successfully in the international markets it chooses to enter.

having a board that actively monitors top-level managers' decisions and actions

does not ensure high performance -boards with members having significant relevant experience and knowledge are the most likely to help the firm formulate and implement effective strategies.

the board is

expected to oversee managers and to ensure that the corporation operates in ways that will best serve stakeholders' interests, and particularly the owners' interests -Helping board members reach their expected objectives are their powers to direct the affairs of the organization and reward and discipline top-level managers.

There are a number of defense tactics top-level managers can use to

fend off a takeover attempt

Effectively using executive compensation as a governance mechanism is particularly challenging for

firms implementing international strategies -the interests of the owners of multinational corporations may be best served by less uniformity in the firm's foreign subsidiaries' compensation plans.* Developing an array of unique compensation plans requires additional monitoring, potentially increasing the firm's agency costs

because of globalization, major companies want to attract foreign investment. For this to happen,

foreign investors must be confident that adequate corporate governance mechanisms are in place to protect their investments.

poison pill

-allows shareholders (other than the acquirer) to convert "shareholders' rights" into a large number of common shares if an individual or company acquires more than a set amount of the target firm's stock (typically 10 to 20 percent). Increasing the total number of outstanding shares dilutes the potential acquirer's existing stake. -This means that, to maintain or expand its ownership position, the potential acquirer must buy additional shares at premium prices, increasing the potential acquirer's costs

the market for corporate control

-an external corporate governance mechanism -this market is a set of potential owners seeking to acquire undervalued firms and earn above-average returns on their investments by replacing ineffective top-level management teams

why is there a recent global emphasis on corporate governance

-apparent failure of corporate governance mechanisms to adequately monitor and control top-level managers' decisions -evidence that a well-functioning corporate governance system can create a competitive advantage for an individual firm -collectively reflects the societal standards of nations

three internal governance mechanisms

1. ownership concentration, represented by types of shareholders and their different incentives to monitor managers 2. the board of directors 3. executive compensation.

CEO duality

-A situation in which an individual holds both the CEO and chair of the board title -others argue that having outside directors is not enough to resolve the problems in that CEO power can strongly influence a board's decision. One proposal to reduce the power of the CEO is to separate the chair's role and the CEO's role on the board so that the same person does not hold both positions

rules regarding types of directors on the board

-In response to the SEC's proposal, in 1984 the New York Stock Exchange (NYSE) implemented a rule requiring outside directors to head the audit committee. -Subsequently, after SOX was passed, other new rules required that independent outsider directors lead important committees such as the audit, compensation, and nomination committees.* -Policies of the NYSE now require companies to maintain boards of directors that are composed of a majority of outside independent directors and to maintain full independent audit committees. -Thus, additional scrutiny of corporate governance practices is resulting in a significant amount of attention being devoted to finding ways to recruit quality independent directors and to encourage boards to take actions that fully represent shareholders' best interests

outside directors and equity stakes

-Increasingly, outside directors are being required to own significant equity stakes as a prerequisite to holding a board seat. In fact, some research suggests that firms perform better if outside directors have such a stake; the trend is toward higher pay for directors with more stock ownership, but with fewer stock options. -One study found that director stock ownership leads to better firm acquisition outcomes.* -However, other research suggests that too much ownership can lead to lower independence for board members.* -In addition, other research suggests that diverse boards help firms make more effective strategic decisions and perform better over time

corporate governance is

-a complex set of structures designed to provide firm oversight of major strategic issues. At a broader level, it reflects the type of infrastructure provided by individual nations as the frameworks within which companies compete. -Comprehensive in scope and complex in nature -an increasingly important part of the strategic management process

diffuse ownership

-a large number of shareholders with small holdings and few, if any, large-block shareholders -produces weak monitoring of managers' decisions. -makes it difficult for owners to effectively coordinate their actions.

family-owned firms - problems

-as they grow, they may not have access to all of the skills needed to effectively manage the firm and maximize returns for the family. Thus, outsiders may be required to facilitate growth. -Second, as they grow, they may need to seek outside capital and thus give up some of the ownership -owner-managers may contract with managerial specialists. These managers make major decisions in the owners' firm and are compensated on the basis of their decision-making skills. -Research suggests that firms in which families own enough equity to have influence without major control tend to make the best strategic decisions

having a large number of outside board members can also create some problems

-because outsiders typically do not have contact with the firm's day-to-day operations and do not have ready access to detailed information about managers and their skills, they may lack the insights required to fully and effectively evaluate their decisions and initiatives, especially when they are busy serving on multiple boards.* -Outsiders can, however, obtain valuable information through frequent interactions with inside board members and during board meetings to enhance their understanding of managers and their decisions

SOX

-has been controversial to some, -some believe that its use has led to generally positive outcomes in terms of protecting stakeholders and certainly shareholders' interests -has arguably improved the internal auditing scrutiny (and thereby trust) in firms' financial reporting -some argue that it creates excessive costs for firms

Dodd-Frank

-includes provisions related to the categories of consumer protection, systemic risk oversight, executive compensation, and capital requirements for banks. -creates a Financial Stability Oversight Council headed by the Treasury Secretary, -establishes a new system for liquidation of certain financial companies, -provides for a new framework to regulate derivatives, -establishes new corporate governance requirements -regulates credit rating agencies and securitizations

insiders vs outsiders

-insiders have access to information that facilitates forming and implementing appropriate strategies. some evidence suggests that boards with a critical mass of insiders typically are better informed about intended strategic initiatives, the reasons for the initiatives, and the outcomes expected from pursuing them. -outsider-dominated boards may emphasize financial, as opposed to strategic, controls to gather performance information to evaluate managers' and business units' performances. A virtually exclusive reliance on financial evaluations shifts risk to top-level managers who, in turn, may make decisions to maximize their interests and reduce their employment risk. Reducing investments in R&D, further diversifying the firm, and pursuing higher levels of compensation are some of the results of managers' actions to reach the financial goals set by outsider-dominated boards. -boards can make mistakes in strategic decisions because of poor decision processes, and in CEO succession decisions because of the lack of important information about candidates as well as the firm's specific needs. -Overall, knowledgeable and balanced boards are likely to be the most effective over time

the modern public corporation

-is based on the efficient separation of ownership and managerial control -Supporting the separation is a basic legal premise suggesting that the primary objective of a firm's activities is to increase the corporation's profit and, thereby, the owners' (shareholders') financial gains

An agency relationship exists when

-one or more persons (the principal or principals) hire another person or persons (the agent or agents) as decision-making specialists to perform a service -one party delegates decision-making responsibility to a second party for compensation

Factors that affect shareholders' preferences include

-the firm's primary industry, -the intensity of rivalry among competitors in that industry, -the top management team's experience with implementing diversification strategies, -the firm's perceived expertise in the new business and its effects on other firm strategies, such as its entry into international markets

Free cash flow

-the source of another potential agency problem. -Calculated as operating cash flow minus capital expenditures, free cash flow represents the cash remaining after the firm has invested in all projects that have positive net present value within its current businesses -when managers use free cash flow to diversify the firm in ways that do not have a strong possibility of creating additional value for shareholders, the firm can become overdiversified. shareholders may prefer that free cash flow be distributed to them as dividends or stock buybacks, so they can control how the cash is invested

family-owned firms

-those managing small firms also own a significant percentage of the firm. -there is less separation between ownership and managerial control. -mostly, ownership and managerial control are not separated to any significant extent. -Research shows that family-owned firms perform better when a member of the family is the CEO rather than when the CEO is an outsider

other examples of agency relationships

-top managers who hire subsidiary managers -client firms engaging consultants -insured contracting with an insurer -managers and their employees -top-level managers and the firm's owners

golden parachutes

-where a CEO can receive up to three years' salary if his or her firm is taken over - are controversial

what are the 7 defense strategies against a hostile takeover

1. Capital structure change 2. corporate charter amendment 3. golden parachute 4. greenmail 5. litigation 6. poison pill 7. standstill agreement

Generally, board members (often called directors) are classified into one of three groups

1. Insiders 2. Related Outsiders 3. Outsiders *Dr. Cory wants different titles for test

The demand for greater accountability and improved performance is stimulating many boards to voluntarily make changes. Among these changes are:

1. increases in the diversity of the backgrounds of board members (e.g., a greater number of directors from public service, academic, and scientific settings; a greater percentage of ethnic minorities and women; and members from different countries on boards of U.S. firms); 2. the strengthening of internal management and accounting control systems; 3. establishing and consistently using formal processes to evaluate board members' performance; 4. modifying the compensation of directors, especially reducing or eliminating stock options as a part of their package 5. creating the "lead director" role* that has strong powers with regard to the board agenda and oversight of non-management board member activities

executive compensation—especially long-term incentive compensation—is complicated. why?

1. the strategic decisions top-level managers make are complex and nonroutine, meaning that direct supervision (even by the firm's board of directors) is likely to be ineffective as a means of judging the quality of their decisions. The result is a tendency to link top-level managers' compensation to outcomes the board can easily evaluate, such as the firm's financial performance 2. the effects of top-level managers' decisions are stronger on the firm's long-term performance than its short-term performance. This reality makes it difficult to assess the effects of their decisions on a regular basis (e.g., annually). 3. a number of other factors affect a firm's performance besides top-level managerial decisions and behavior. Unpredictable changes in segments (economic, demographic, political/legal, etc.) in the firm's general environment make it difficult to separate the effects of top-level managers' decisions and the effects (both positive and negative) of changes in the firm's external environment on the firm's performance.

Summary 9

Corporate governance structures used in Germany, Japan, and China differ from each other and from the structure used in the United States. Historically, the U.S. governance structure focused on maximizing shareholder value. In Germany, employees, as a stakeholder group, take a more prominent role in governance. By contrast, until recently, Japanese shareholders played virtually no role in monitoring and controlling top-level managers. However, Japanese firms are now being challenged by "activist" shareholders. In China, the central government still plays a major role in corporate governance practices. Internationally, all these systems are becoming increasingly similar, as are many governance systems both in developed countries, such as France and Spain, and in transitional economies, such as China.

Summary 8

In general, evidence suggests that shareholders and boards of directors have become more vigilant in controlling managerial decisions. Nonetheless, these mechanisms are imperfect and sometimes insufficient. When the internal mechanisms fail, the market for corporate control—as an external governance mechanism—becomes relevant. Although it, too, is imperfect, the market for corporate control has been effective in improving corporations' diversification portfolios and implementing more effective strategic decisions.

Summary 6

In the United States and the United Kingdom, a firm's board of directors, composed of insiders, related outsiders, and outsiders, is a governance mechanism expected to represent shareholders' interests. The percentage of outside directors on many boards now exceeds the percentage of inside directors. Through implementation of the SOX Act, outsiders are expected to be more independent of a firm's top-level managers compared with directors selected from inside the firm. Relatively recent rules formulated and implemented by the SEC to allow owners with large stakes to propose new directors are beginning to change the balance even more in favor of outside and independent directors. Additional governance-related regulations have resulted from the Dodd-Frank Act.

Summary 5

Ownership concentration is based on the number of large-block shareholders and the percentage of shares they own. With significant ownership percentages, such as those held by large mutual funds and pension funds, institutional investors often are able to influence top-level managers' strategic decisions and actions. Thus, unlike diffuse ownership, which tends to result in relatively weak monitoring and control of managerial decisions, concentrated ownership produces more active and effective monitoring. Institutional investors are a powerful force in corporate America and actively use their positions of concentrated ownership to force managers and boards of directors to make decisions that best serve shareholders' interests.

Summary 3

Ownership is separated from control in the modern corporation. Owners (principals) hire managers (agents) to make decisions that maximize the firm's value. As risk-bearing specialists, owners diversify their risk by investing in multiple corporations with different risk profiles. Owners expect their agents (the firm's top-level managers, who are decision-making specialists) to make decisions that will help to maximize the value of their firm. Thus, modern corporations are characterized by an agency relationship that is created when one party (the firm's owners) hires and pays another party (top-level managers) to use its decision-making skills.

Finding the appropriate level of diversification is difficult for managers.

Research has shown that too much diversification can have negative effects on the firm's ability to create innovation (managers' unwillingness to take on higher risks). Alternatively, diversification that strategically fits the firm's capabilities can enhance its innovation output.* However, too much or inappropriate diversification can also divert managerial attention from other important firm activities such as corporate social responsibility

Summary 4

Separation of ownership and control creates an agency problem when an agent pursues goals that conflict with the principals' goals. Principals establish and use governance mechanisms to control this problem.

More intensive application of governance mechanisms as mandated by legislation such as SOX and Dodd-Frank

affects firms' choice of strategies -more intense governance might find firms choosing to pursue fewer risky projects, possibly decreasing shareholder wealth as a result, although some research suggests that tighter governance associated with SOX regulation increases innovation, especially for firms with previously weaker governance

Some firms

amend the corporate charter so board member elections are staggered, resulting in only one third of members being up for reelection each year. Research shows that this results in reduced vulnerability to hostile takeovers but also provides for better long-term investments.

Insiders

are active top-level managers in the company who are elected to the board because they are a source of information about the firm's day-to-day operations -The firm's CEO and other top-level managers

Long-term incentive plans (typically involving stock options and stock awards)

are an increasingly important part of compensation packages for top-level managers. -Theoretically, using long-term incentives facilitates the firm's efforts (through the board of directors' pay-related decisions) to avoid potential agency problems by linking managerial compensation to the wealth of common shareholders. -Effectively designed long-term incentive plans have the potential to prevent large-block stockholders (e.g., institutional investors) from pressing for changes in the composition of the board of directors and the top-management team because they assume that, when exercised, the plans will ensure that top-level managers will act in shareholders' best interests. -Additionally, shareholders typically assume that top-level managers' pay and the firm's performance are more properly aligned when outsiders are the dominant block of a board's membership. -Research results suggesting that fraudulent behavior can be associated with stock option incentives, such as earnings manipulation,* demonstrate the importance of the firm's board of directors (as a governance mechanism) actively monitoring the use of executive compensation as a governance mechanism.

Institutional owners

are financial institutions, such as mutual funds and pension funds, that control large-block shareholder positions -as large-block shareholders, have the potential to be a powerful governance mechanism. -Estimates of the amount of equity in U.S. firms held by institutional owners range from 60 to 75 percent. -pension funds are critical drivers of growth and economic activity in the United States because they are one of the most significant sources of long-term, patient capital

Agency costs

are the 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 -Because monitoring activities within a firm is difficult, the principals' agency costs are larger in diversified firms given the additional complexity of diversification

The market for corporate control

is an external governance mechanism that is active when a firm's internal governance mechanisms fail -The market for corporate control is composed of individuals and firms that buy ownership positions in or purchase all of potentially undervalued corporations typically for the purpose of forming new divisions in established companies or merging two previously separate firms. -Because the top-level managers are assumed to be responsible for the undervalued firm's poor performance, they are usually replaced. An effective market for corporate control ensures that ineffective and/or opportunistic top-level managers are disciplined.

Ownership concentration

is defined by the number of large-block shareholders and the total percentage of the firm's shares they own. -influences decisions made about the strategies a firm will use and the value created by their use

Managerial opportunism

is the seeking of self-interest with guile (i.e., cunning or deceit). -Opportunism is both an attitude (i.e., an inclination) and a set of behaviors (i.e., specific acts of self-interest) -principals establish governance and control mechanisms to prevent agents from acting opportunistically, even though only a few are likely to do so

Corporate governance

is the set of mechanisms used to manage the relationships among stakeholders and to determine and control the strategic direction and performance of organizations -concerned with identifying ways to ensure that decisions (especially strategic decisions) are made effectively and that they facilitate a firm's efforts to achieve strategic competitiveness

Because corporate governance is an ongoing process concerned with how a firm is to be managed

its nature evolves in light of the types of never-ending changes in a firm's external environment

A rule approved by the SEC allows

large shareholders (owning 1 to 5 percent of a company's stock) to nominate up to 25 percent of a company's board of directors and enhances shareholders' decision rights

Ownership concentration as a governance mechanism has received considerable interest, because

large-block shareholders are increasingly active in their demands that firms adopt effective governance mechanisms to control managerial decisions so that they will best represent owners' interests.

For top-level managers, a board's decision to accept an acquiring firm's offer typically finds them

losing their jobs because the acquirer usually wants different people to lead the firm. At the same time, rejection of an offer also increases the risk of job loss for top-level managers because the pressure from the board and shareholders for them to improve the firm's performance becomes substantial.

In free market countries, the primary goal of a publicly traded company is to

maximize shareholder value. However, only the debt holders can put a company into default if they haven't received payments on the debt. In addition, the Government is not typically one of the major parties involved in "corporate governance." Corporate governance is usually focused on the relationship between managers, boards of directors, and common shareholders

An awareness on the part of top-level managers about the existence of external investors in the form of individuals (e.g., Carl Icahn) and groups (e.g., hedge funds) often

positively influences them to align their interests with those of the firm's stakeholders, especially the shareholders. Moreover, when active as an external governance mechanism, the market for corporate control has brought about significant changes in many firms' strategies and, when used appropriately, has served shareholders' interests

In contrast, activist hedge funds (as part of the market for corporate control) are

proactive; they identify firms whose performance could be improved and then invest in them.

the separation and specialization of ownership (risk bearing) and managerial control (decision making) should

produce the highest returns for the firm's owners

The separation of ownership and managerial control allows shareholders to

purchase stock, which entitles them to income (residual returns) from the firm's operations after paying expenses -This right, however, requires that shareholders take a risk that the firm's expenses may exceed its revenues. To manage this investment risk, shareholders maintain a diversified portfolio by investing in several companies to reduce their overall risk.* The poor performance or failure of any one firm in which they invest has less overall effect on the value of the entire portfolio of investments. Thus, shareholders specialize in managing their investment risk.

In general, activist pension funds (as institutional investors and as an internal governance mechanism) are

reactive in nature, taking actions when they conclude that a firm is underperforming

research results show that using takeover defenses

reduces the amount of pressure managers feel to seek short-term performance gains, resulting in them concentrating on developing strategies with a longer time horizon and a high probability of serving stakeholders' interests. Such firms are more likely to invest in and develop innovation; when they do so, the firm's market value increases, thereby rewarding shareholders

the most effective boards

set boundaries for their firms' business ethics and values.* After the boundaries for ethical behavior are determined, and likely formalized in a code of ethics, the board's ethics-based expectations must be clearly communicated to the firm's top-level managers and to other stakeholders (e.g., customers and suppliers) with whom interactions are necessary for the firm to produce and sell its products

Who elects the board of directors?

shareholders

an advantage to severance packages is

that they may encourage top-level managers to accept takeover bids with the potential to best serve shareholders' interest.*

the U.S. Congress enacted

the Sarbanes-Oxley Act (SOX) in 2002 and passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in mid-2010.

Though important to all shareholders, a firm's individual shareholders with small ownership percentages are very dependent on

the board of directors to represent their interests. Unfortunately, evidence suggests that boards have not been highly effective in monitoring and controlling top-level managers' decisions and subsequent actions

In the United States, shareholders are commonly recognized as

the company's most significant stakeholders -Increasingly though, top-level managers are expected to lead their firms in ways that will also serve the needs of product market stakeholders (e.g., customers, suppliers, and host communities) and organizational stakeholders (e.g., managerial and non-managerial employees).* Therefore, the firm's actions and the outcomes flowing from them should result in, at least, minimal satisfaction of the interests of all stakeholders; otherwise a firm risks seeing its dissatisfied stakeholders withdraw their support from the firm and provide it to another (e.g., customers will purchase products from a supplier offering an acceptable substitute).

ownership of many modern corporations is now concentrated in

the hands of institutional investors rather than individual shareholders

shareholders seek

the level of diversification that reduces the risk of the firm's total failure while simultaneously increasing its value by developing economies of scale and scope

Because of the importance of boards of directors in corporate governance and as a result of increased scrutiny from shareholders—in particular, large institutional investors—

the performances of individual board members and of entire boards are being evaluated more formally and with greater intensity

Most institutional investors oppose

the use of defense tactics because such defenses are generally seen as a way to entrench top managers in their positions. -Many institutional investors also oppose severance packages (golden parachutes)

Large-block shareholders

typically own at least 5 percent of a company's issued shares.