Chapter 13
Germany
read page 463-464
China
read pages 464
Triple Bottom Line
A firm's strategy and related investments have financial performance objectives, social objectives and environmental objectives.
Restricted Stock
Associated with annual bonus plans and stock options. Ties executives' financial rewards to shareholder value while avoiding the lack of downside risk associated with stock options companies can grant actual stock shares to executives. Grants have restrictions built in to ensure that managers do not sell the stock to convert it to cash Restrictions usually entail vesting over a period of 3-5 years and prohibitions on the sale of the stock for some extended period of time. Downsides: when stock price drops, so does the value of the executives restricted stock.
The Board's Activities and the Company's Strategy
Boards generally organized into several committees, with key board responsibilities being assigned to different committees. Boards have compensation committees that are charged with setting the level of executive compensation. Roles/Actions 1. Monitoring (executive compensation, executive succession, audit review) 2. Advice (counseling CEO) 3. Advocacy (relationships with lenders, suppliers and customers)
Using Board as a Lever of Power and Influence
Boards provide access to external resources, and it is not uncommon for a director to sit on multiple boards (called board interlock). Resources range from access to capital, to new knowledge, to the ability to influence other external stakeholders. Some people believe such influence and power can get out of hand. CEOcentric: from the standpoint that CEOS may be tempted to seek out other CEOs to sit on their boards if those potential board members are high paid at their home firms, which are then likely to vote for higher payment for the CEOs.
CEO Chair
CEO also serves as the chair of the board of directors. Unlike other countries, in the U.S. there is resistance to separating the roles of CEO and board chair. When roles are split, it is critical that the board chair not take operational roles, just as the ceo shouldn't attempt to run the board. Logic for combining the two: 1. The need for specialized information that an outside could not have 2. A lack of qualified candidates Logic for Splitting: 1. need for monitoring
Executive Compensation
Can structure incentive arrangements so that managers are rewarded for doing what is in stockholders' best interests.
Market for Corporate Control
Control over public corporations is traded and this theoretically puts some pressure on managers to perform, otherwise their corporation can be taken over. Corporate control: literally refers to who controls the corporation Achieved by having sufficient power and votes to choose the CEO and members of the board of directors of a company and to control all major decisions made by a company. Principle ways of gaining corporate control is through M&As. Market for corporate control helps to keep managers in line.
Corporate Governance and Strategy
Corporate governance and related to strategy formulation and implementation in several ways: 1. In establishing controls and incentives 2. Boards should ensure that firms's vision and missions are reflected in its strategy, monitor the way that strategy is executed, and ensure that top executives reap appropriate career and financial consequences in cases of failure or success. Risk increases that managers will deviate from an organization's stated purpose and its guiding documents when managers are not owners of the firm.
Trend Towards Takeovers and Buyouts
Corporate takeovers generative positive gains, that target firm's shareholders benefits, and that the bidding firm's shareholders do not lose out. Success of a hostile takeover depends on the takeover premium paid. Market for corporate control can be viewed as an arena in which managerial teams compete for the rights to manage corporate resources. Costly and time-consuming remedy to implement, and its benefits to the buyer will always be of concern. The market for corporate control can only be an effective governance mechanism to the extent that the capital markets and governance mechanisms in place in a country allow hostile acquisitions to occur in the first place.
Public Company Accounting Oversight Board (PCAOB)
Created Sarbanes-Oxley. To oversee the audits of public companies. Sets standards and rules for audit reports. All accounting firms that audit public companies must register with the oversight board. Board inspects, investigates, and enforces compliance by these registered firms. Four agency control mechanisms: 1. ownership concentration and power 2. boards of directors 3. incentive compensation 4. the market for corporate control
Differing National Governance Practices
Effects of particular governance mechanisms are somewhat dependent on the national context in question. read page 463
Insiders vs. Outsiders
Executives of the firm who serve on the board are referred to as insiders Those on board who are not employed by the firm otherwise are known as outsiders. Most institutional investors and watchdog groups prefer a large majority of independent directors to help avoid conflicts of interests in carrying out fundamental responsibilities. However, insiders have more access to more critical knowledge of the business and its environment and have the potential to add critical insight to board deliberations.
Monitoring
Functioning of the board in exercising its legal and fiduciary responsibility to oversee executives' behavior and performance and to take action when it's necessary to replace management. Important Decisions: 1. Hiring and firing the CEO and other senior executives 2. Ensuring that the board has an executive succession plan that keeps the firm prepared in the event that a new CEO is needed Routine Monitoring Mechanisms: 1. Meeting regularly as a board 2. Hiring competent external auditors 3. Diligently reviewing financial and operating results
The Board of Directors
Group of individuals that formally represents the firm's shareholders and overseas the work of top executives. Legal roles: 1. hiring and firing top management 2. monitoring management 3. ensuring the shareholders' interests are protected 4. establishing executive compensation 5. reviewing and approving the firm's strategy General responsibility is to ensure that executives are acting in shareholders' best interests.
Codes of Governance
Ideal governance standards formulated by regulatory, market and government institutions. Aimed at four main issues: 1. Shareholder equity (upholding all shareholder rights) 2. Accountability by the board and management 2. Disclosure and transparency through accurate and timely financial and nonfinancial reporting 4. Independence (audits and oversight, directors)
The Cadbury Code
In the United Kingdom. Help raise corporate governance standards and increase the level of confidence in financial reporting and auditing by clarifying the respective responsibilities and obligations of relevant entities. Report issued that made 19 recommendations for better firm governance.
The Sarbanes-Oxley Act
In the United States Requires all companies to file periodic reports with SEC. Noncompliance comes with significant penalties. Essential components: 1. accounting oversight 2. auditor independence 3. disclosure 4. analysts' conflicts of interests 5. accountability for fraud 6. attorney's responsibilities
Stock Options
Incentive device giving an employee the right to buy a share of company stock at a later date for a predetermined price. Idea is to simulate stock ownerships for executives who do not or cannot buy lots of stock. Usually impose a vesting period, typically 3 years. After that period, employee can redeem the option. If the stock price has increased, can buy the stock at a discount. Rationale is that it motivates executives to act like owners and take reasonable risk that will result in the company's tock price increasing. Downside: 1. Do not always achieve the objective of stock ownership 2. Only cost to executives is an opportunity cost Decision makers behave quite differently when they have something to lose. May increase excessive risk taking beyond the level of risk desired by shareholders.
Executive Ownership
Most direct way to align incentives is to require that executives own stock in the firm. If one is an owner of the company than they would be more likely to behave like an owner. Can backfire because an individual executive is likely to have a very unbalanced investment portfolio.
Bonus Plans
Oldest form of incentive pay is the bonus plan. The board can subjectively evaluate executives' performance on multiple dimensions and allocate a year-end cash award as appropriate. Should be linked to firm performance indications. Drawbacks: 1. Executives may be motivated to make accounting decisions that maximize their possible bonus payout 2. Has unintended consequence of short-term bias and inattention to long-term strategic needs Many firms are now trying to tie bonus plans to long-term performance (long-term incentive plans) Appealing characteristics of bonus plans: 1. board can tie them to multiple desired outcomes, including financial and others such as customer satisfaction 2. Can easily be revoked or withheld.
Agent
Party, such as a manager, who acts on behalf of another party
Principal
Party, such as a shareholder, who hires an agent to act on his or her behalf.
Institutional Owners
Pension or mutual fund that manages large sums of money for third-party investors. Usually relatively passive investors. Vote by purchasing or selling stock based on their outlook for the firms' performance and the potential performance of the firm's stock. Can become active if the need arises. Different types of institutional investors seem to have preferences for firms with different strategies.
Agency Problem
Separation of its ownership from managerial control of a firm. Once shareholders invest in a firm, they have relatively little direct control over what happens within the firm. Solution for shareholders is to find ways to ensure that corporate resources and profits are not squandered, executives will not make choices that benefit themselves at shareholders, and shareholders will receive a positive return on their investment.
Dispersion of Ownership
Some firms have a few select owners who control significant stakes in the firm. These parties have so much voting power that they can have significant influence and control over the firm's strategy and governance. Can use that influence to determine who stays in power as CEO or chair of the board Dispersion of stock ownership affects the type and magnitude of agency problems that investors face. Presence of a powerful owner does not remove all forms of agency problems: 1. when a single owner uses that power to extract private benefits from the company at the expense of other, less powerful owners. Some shareholders are in a position to influence corporate policies. Blockholders: stakeholders who control 5% or more of a firm's shares. This level of ownership must be publicly disclosed.
Faces of Corporate Governance Around the World
Specific nature of the problems and the norms for guarding against them vary. Most firms' problems can be traced to faulty governance, fraudulent accounting, and executive excess. Ownership is heavily dispersed in the U.S. but much more concentrated in canada, germany, japan and china. National and state governments often own major stakes of public companies in germany, japan, and china. Board composition differs greatly from country to country: owners and worked typically sit on the board in france, germany, japan and china. Outsiders and managers occupy seats in U.S., U.K., and canadian companies.
Ownership and the Roles of Owner
Subdivided into different ownership types, such as public and private firms. Private firm is one in which the owner(s) has not listed shares of the firm on a public exchange. Shares are typically owned largely by the founding families or by an investment group. A public firm has sold shares to the general investing public, but how those publicly traded shares are dispersed or concentrated varies significantly and leads to another way to categorize public firms.
Corporate Governance
The system by which owners of firms direct and control the affairs of the firm. Addresses the distribution of rights and responsibilities among different participants in the organization Spells out rules and procedures for making decisions on corporate affairs Provides structure through which the company's objectives are set and the means of attaining those objectives and monitoring performance.
Incentive Compensation
Two most common types: 1. annual bonus plans 2. Stock options
Stock-Ownership Policies
Two types: 1. Traditional Establishes ownership levels through a multiple-of-salary approach. 2. Retention Express ownership as a percentage of the gains resulting from the exercise of stock options and other equity-based incentives, such as restricted stock. Requires time to implement. Most CEOS cannot afford to immediately buy the needed shares when a plan is implemented. Allow CEOs several years to acquire the required shares. No time requirement is necessary for retention method.
Incentive Alignment
Use of incentives to align managerial self-interest with shareholders.
Advising Managers
Value is to be had by tapping into the expertise and contacts of the board and using board members as confidants and information sources. Critics of corporate governance put shareholders at risk because these relationships may make the board less likely to monitor the CEO effectively. Research shows: 1. social ties typically fail to reduce the level of board-monitoring activity, instead increasing the ability of the CEO to tap board members for advice and counsel on strategic issues 2. CEOs that perceive they have a loyal board will involve the board more in strategic decision-making 3. Firms in which CEOs collaborate with the board members on strategic issues outside of board meetings perform better than firms that limit CEO/board interactions to purely monitoring roles. When firms are in relatively stable competitive environments, monitoring of board members is enhanced when outside board members are from other firms that are strategically related to the firm. When a firm is located in a very unstable competitive environment, board involvement is most effective when outside board members are drawn from strategically dissimilar firms.
Major Question for Corporate Governance
What effect does corporate governance have on firm survival, performance, and competitive advantage?
Well-Designed Incentive Plan
monetary awards are powerful tools that can be used to increase the likelihood that executives act in shareholders' interests. Proper use of incentives tied to long-term performance metrics increases the likelihood that executives will make necessary capital investments. Option pay should be used in moderation and balanced with other types of incentives. Too much focus placed on keeping the CEO's pay level in line with market forces and not enough focus has been placed on the incentives of other key executives. Large gaps in pay across top managerial ranks suffer negative effects, i.e. high turnover.
