Chapter 10 MGMT 493

Standstill Agreement

A contract between the target firm and the potential acquirer speci- fying that the acquirer will not purchase additional shares of the target firm for a specified period of time in exchange for a fee paid by the target firm

internal governance mechanisms

A firm's poor performance, often demonstrated by the firm's earning below-average returns, is an indicator that _______________________________have failed; that is, their use did not result in managerial decisions that maximized shareholder value.

Golden Parachute

A lump-sum payment of cash that is given to one or more top-level managers when the firm is acquired in a takeover bid

CEO Duality

A situation in which an individual holds both the CEO and chair of the board title is called

Aufsichtrat

Appointment to the management board is the responsibility of the _____________ or supervisory board. Despite the ability of major owners and oaks to monitor control the managers of large German firms, maximizing shareholder value has not been a historical focus. However, this is changing.

True

As discussed in this section, the changes in governance that are taking place in Germany and Japan are representative of the twenty-first century competitive landscape, where customer demands are becoming more similar and shareholder value is becoming a more significant focus of managerial agents.

ensure that strategic decisions are made effectively

At its core, corporate governance is concerned with identifying ways to:

because insiders dominate the board by limiting the flow of information to outside directors and outside directors are nominated for board membership by insiders (primarily by the CEO) and thus are indebted to insiders.

Why are outside directors (and boards) perceived as innefective?

Increased diversification generally drives the growth of the firm and firm growth is positively related to managerial compensation. Thus, by diversifying to a greater extent than may be desired by shareholders, managers may enjoy the higher levels of compensation that accompany managing larger firms.

Why do managers enjoy higher product diversification?

True

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 man- agers and their skills, they lack the insights required to fully and effectively evaluate their decisions and initiatives. But that can get outside information

all stakeholders and the firm's future.

corporate governance mechanisms increasingly affect_______________.

slack resources or free cash flows

creased diversification also may provide managers with access to increased levels of ___________________, resources that are generated after investment in all internal projects that have positive net present values within the firm's current product lines. Managers may choose to invest excess funds in products or activities that are not related to the firm's existing core businesses and products if they perceive attractive (positive net present value) investment opportunities.

Agency Relationship

exists when one party (the principal[s]) delegates decision making to another party (the agent[s]) in return for compensation as a decision-making specialist who performs a service. This relationship can be broader than just owners and managers—e.g., consultants and clients or insured and insurer.

1) Strategic decisions made by top managers are complex and non-routine. Due to difficulties in judging decision quality, compensation is often linked to more measurable outcomes such as financial performance. 2) Decisions made by top-level managers are likely to affect firm performance over an extended period of time. As a result, it is difficult to assess the effect of current decisions using current period performance. 3)Many variables (or outside factors) intervene between management behavior and firm performance (e.g., uncontrollable shifts in the environment).

Developing and implementing an effective incentive compensation program is quite challenging because:

Capital structure change

Dilution of the target firm's stock, making it more costly for an acquiring firm to continue purchasing the target's shares. Employee stock option plans (ESOPs), recapitalization, issuance of additional debt, and share buybacks are actions associated with this strateg

obligation, family, and consensus.

Corporate governance in Japan is affected by the concepts of:

True

Corporate governance involves oversight (election and pay) in areas where owners, managers, and members of the firms board of directors may have conflict of interest

managerial autonomy must be controlled by the firm's board of directors or by other governance mechanisms that encourage managers to make strategic decisions that are in the best interests of shareholders.

For firm diversification to approach the shareholder optimum what has to happen?

50%/5%

Furthermore, a review of the research suggests that over time, firm size has accounted for more than ____________of the variance in total CEO pay, while firm performance has accounted for less than ______________ of the variance.

True

Furthermore, large financial institution shareholders—such as banks—are effectively prevented from having direct ownership of firms and are prohibited from placing a representative on the boards of directors.

2,000 eployees

German firms with more than _________________ are required to have a two-tiered board structure that places the responsibility for monitoring and controlling managerial (or super- visory) decisions and actions in the hands of a separate group.

True

Governance mechanisms discussed in this chapter are focused on ensuring that managers work effectively toward meeting their obligation to maximize shareholder wealth.

Executive compensation

is a governance mechanism that seeks to align managers' and owners' interests through salary, bonus, and long-term incentive compensation such as stock options.

Corporate Governance

is a relationship among stakeholders that is used to determine and control the direction and performance of organizations.

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."

Sherholders (principles) are the owners, they hire managers (Agents) who are decision makers. In this the principles are the risk bearing specialist paying compensation to a managerial decisions making speciality (agent)

Describe the agency relationship

to monitor and ratify major managerial actions to protect the interests of owners

Because the primary role of the board of directors is __________________, there is a call by advocates of board reform that outsiders should represent a significant majority of a board's membership.

Diffuse Ownership

(a large number of shareholders with small holdings and few/no large-block shareholders) 1) produces weak monitoring of managerial decisions 2) makes it difficult for owners to coordinate their actions effectively 3) may result in levels of diversification that are beyond the optimum level desired by shareholders (especially when this condition is combined with weak monitoring)

Litigation Lawsuits that help the target firm stall hostile takeover attempts:

: Antitrust charges and inadequate disclosure are examples of the grounds on which the target firm could file.

increase risk for managers

Because the market for corporate control tends to _____________________, man- agerial pay may be augmented indirectly through golden parachutes (where a CEO can receive up to three years' salary if his or her firm is taken over)

Managerial manipulation

Although incentive compensation plans may increase the value of a firm in line

Poison Pill

An action the target firm takes to make its stock less attractive to a potential acquire

managerial opportunism

An agency relationship enables the possibility of ___________________, the seeking of self-interest with guile (i.e., with cunning or deceit), where opportunism is represented by an attitude or inclination and a set of behaviors.

Corporate charter amendment

An amendment to the target firm's charter for the purpose of staggering the elections of members to its board of directors so that all are not elected during the same year. This change to the firm's charter prevents a potential acquirer from installing a completely new board in a single yea

1) managerial pay interventions, such as golden parachutes 2) asset restructuring, such as divesting a business unit or division 3) financial restructuring—e.g., stock repurchases, paying out a firm's free cash flows as a dividend 4) changing the state of incorporation 5) making targeted shareholder repurchases (known as greenmail

Because of the threat of dismissal, managers have devised a number of defensive tactics designed to both ward off takeovers and buffer or protect managers from external governance mechanisms. These tactics include:

True

However, other research sug- gests that too much ownership can lead to lower independence for board members

15 percent of the banks captiol

In Germany bank ownership of a single firms stock is limited to:

major shareholders

In Germany banks become _______ when companies that they financed either sought new capital in the stock market or defaulted on loans

10 percent

In Germany banks generally hold less than _______ of a firms stock

financing and monitoring firms.

In Japan Banks occupy an important position in the governance system, both _______________ and____________ firms.

the closest relationship with the company's top executives.

In Japan The bank owning the largest share of stocks and the largest amount of debt—the main bank—has ________________

family, keiretsu

In Japan The concept of____________goes beyond the American concept to include the firm—individuals see themselves as members of a company family. And this concept is extended to include members of the firm's ___________ a group of firms that are tied together by cross-shareholdings, interrelationships, and interdependencies

he main bank—the bank holding the largest share of a firm's debt

In Japan __________________provides financial advice and assumes primary responsibility for monitoring the firm's management.

obligation

In Japan, _______________ goes beyond principles but is more a product of specific causes, events, and relationships. It can mean returning a service for one that has been rendered.

True

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.

Japanese firm's keiretsu

In many cases, bank relations are an integral part of the ___________ (an industrial group of firms that interact with the same bank).

owner and manager

In many private and public German firms, _____________________may be the same individual. In these instances, agency problems are not present.

True

In recent years, large block ownership by individuals has declined, but they have been replaced by significant positions held by institutional owners.

Managerial Employment Risk

Increased product diversification can also reduce ________________he risk of job loss, loss of compensation, or loss of managerial reputation. Increased diversification reduces managerial employment risk because the firm (and the manager) is less affected by a reduction in demand for (or failure of) a single product line when the firm produces and sells multiple products.

5/40

Japanese banks can hold up to_____ percent of a firm's stock. Groups of banks can hold up to ______percent of a firm's stock.

stock options and stock in the total pay packages

Large CEO compensation packages result mostly from the inclusion of _____________

directing the affairs of the organization, punishing (disciplining) and rewarding (compensating) managers and protecting the rights and interests of shareholders (owners).

Legally, the board of directors has broad powers, including:

1) increasing the diversity of board members' backgrounds 2) strengthening internal management and accounting control systems 3) establishing and consistently using formal processes to evaluate the board's performance 4) the creation of a "lead director" role that has strong powers with regard to the board agenda and oversight of nonmanagement board member activities 5) changes in the director compensation, especially reducing or eliminating stock options as part of the package Research shows that boards working collaboratively with management: 6) make higher quality strategic decisions 7) make decisions faster 8) become more involved in the strategic decision-making process

Many boards have voluntarily initiated changes, including:

director stock ownership, executive meetings to discuss important strategic issues, and a serious nominating committee that truly controls the nomination process to strongly influence the selection of new members.

One activist concludes that boards need three foundational characteristics to be effective:

True

Option awards became a means of providing large compensation packages, and the options awarded did not relate to the firm's performance, particularly when boards showed a propensity to reprice options at a lower strike price when stock prices fell precipitously. Option awards are becoming increasingly controversial.

the demands of other key stakeholders—such as employees, customers, suppliers, and the community—

Over the long-term, ____________________also must be satisfied in order to maximize shareholder wealth. For that reason, and others, governance mechanisms must be carefully designed and implemented so that managers' attention is not focused on maximizing short-term returns and to ensure that they consider the interests of all stakeholders.

one percent

Research has shown that managers owning more than ____________of the firm's stock are less likely to be forced out of their jobs, even when the firm is performing poorly

True

Research suggests that more intensive application of governance mechanisms may produce significant changes in strategies.

1. increases in the diversity of the backgrounds of board members (e.g., a greater num- ber of directors from public service, academic, and scientific settings; a greater per- centage 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 member's per- formance; 4. modifying the compensation of directors, especially reducing or eliminating stock options as a part of their package; and 5. creating the "lead director" role80 that has strong powers with regard to the board agenda and oversight of non-management board member activities.

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

True

The growth of the large, modern public corporation is based primarily on the efficient separation of ownership and managerial control.

Internal

The market for corporate control generally comes into use as an external governance mechanism only after ________ governance mechanisms have failed.

by a firm's poor performance relative to industry competitors.

The market for corporate control governance mechanism should be triggered

the delegation of the responsibilities of decision making to managers

The potential for conflicts of interests between owners and managers is created by ____.

Greenmail

The repurchase of the target firm's shares of stock that were obtained by the acquiring firm at a premium in exchange for an agreement that the acquirer will no longer target the company for takeover.

CalPERS

The rising tide of shareholder pressure also is evidenced by actions taken by_________.These things provides retirement and health coverage to over 1.3 million current and retired public employees, is generally thought to act aggressively to promote decisions and actions that it believes will enhance shareholder value in companies in which it invests.

(1) ownership concentration, as represented by types of shareholders and their different incentives to monitor managers, (2) the board of directors, and (3) executive compensation. The external governance mechanism is the market for corporate control.

Three internal governance mechanisms examined here are:

True

Unfortunately, having a board that actively monitors top-level managers' decisions and actions does not ensure high performance.

True

Using executive compensation as a governance mechanism is more challenging in international firms.

Insiders, related outsiders and outsiders

What are the three classifications of members of the board of directors?

Deutsche, Dresdner, and Commerzbank

What are the three large banks in Germany that hold majority positions in large firms through their own holding and proxy votes for shareholders who retain shares with the banks.

1) Because outside directors do not have day-to-day contact with the ongoing operations of the firm, they must obtain detailed, in-depth information about the quality of management decisions. Generally this information is obtained through frequent interactions, often developed over time, with inside directors (generally, at board meetings). 2) In the absence of rich information, boards may be forced to emphasize financial rather than strategic controls. Potentially, this means that outsider-dominated boards—because they lack sufficient information—will evaluate managers, not on the basis of the appropriateness of their actions (which the board ratified) but based on the financial outcomes of those actions.

What are the two main drawbacks of outside boards?

concentrated government

What is most important in Germany and even in the United states?

1) Owners prefer that the scope be greater than a dominant business but less than related-linked diversification. 2) Owners' optimum level of diversification is where the S curve turns up, a point between dominant business and related-constrained diversification. 3) Managers prefer a greater scope of diversification than owners. As can be seen from the M curve in Figure 10.2, managers prefer that the firm's diversification be between related-linked and unrelated diversification. 4) However, as the curve indicates, there is a point at which managerial employment risk increases as the firm overdiversifies (as discussed in Chapter 6). 5) The optimum level of firm diversification from a managerial risk perspective is at point B on the M curve, somewhere between related-linked and unrelated businesses.

Why is there there is a conflict between owners and managers regarding the desired levels of firm diversification and risk?

Banks

____ historically have occupied a central position in German governance structure

Outsiders

are individuals who are independent of the firm. They are neither involved in the firm's day-to-day operations, nor do they have other relationships with the firm. An example of an outsider might be the president of a university or a community volunteer.

Related outsiders

are individuals who are not involved in the firm's day-to-day operations, but may have a relationship with the company. Examples might include the firm's legal counsel, a large customer or supplier, or a close relative of one of the firm's top-level managers.

Large-block shareholders

are investors who typically own at least five percent (5 percent) of the firm's shares.

Institutional Owners

are large block shareholder positions controlled by financial institutions, such as stock mutual funds and pension funds.They are becoming much more influential, they also target ineffective boards of directors

Insiders

are represented by the firm's CEO and other top-level managers.

Agency Cost

are the sum of incentive, monitoring, and enforcement costs as well as any residual losses incurred by principals because it is not possible for principals to guarantee 100 percent compliance through monitoring arrangements.

Hedge Fund

is an investment fund that can pursue many different investment strat- egies, such as taking long and short positions, using arbitrage, and buying and selling undervalued securities for the purpose of maximizing investors' returns.

Market for Corporate Control

is composed of individuals and firms who buy ownership positions in (or take over) potentially undervalued firms. They do this in order to form a new division in an established diversified firm, merge two previously separate firms, and usually replace the target firm's management team to revamp the strategy that caused low firm performance

Ownership concentration

is defined both by the number of large-block owners and by the total percentage of the firm's shares that they own.

Consensus

represents one of the most important influences on governance structure in Japan. This requires that managers—among others—expend significant amounts of energy to win the hearts and minds of people rather than proceed by the edicts of top-level managers.

True

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