4490 - 12: Corporate Governance and Business Ethics

GE Example

"ecomagination" - cleaner and more efficient energy, reduce emissions

Auditors, Regulators, Analysts

- Auditors, government regulators, and industry analysts serve as additional external-governance mechanisms. - All public companies listed on the U.S. stock exchanges must file a number of financial statements with the Securities and Exchange Commission (SEC), a federal regulatory agency whose task it is to oversee stock trading and enforce federal securities laws. - To avoid the misrepresentation of financial results, all public financial statements must follow generally accepted accounting principles (GAAP) and be audited by certified public accountants. - As part of its disclosure policy, the SEC makes all financial reports filed by public companies available electronically via the EDGAR database. - This database contains more than 7 million financial statements, going back several years. - Industry analysts scrutinize these reports in great detail, trying to identify any financial irregularities and assess firm performance. - Given recent high-profile oversights in accounting scandals and fraud cases, the SEC has come under pressure to step up its monitoring and enforcement. - Industry analysts often base their buy, hold, or sell recommendations on financial statements filed with the SEC and business news published in The Wall Street Journal, Bloomberg Businessweek, Fortune, Forbes, and other business media such as CNBC. - Researchers have questioned the independence of industry analysts and credit-rating agencies that evaluate companies (such as Fitch, Moody's, and Standard & Poor's).

Market for Corporate Control

- Last resort because it comes with significant transaction costs. - To succeed in its hostile takeover bid, buyers generally pay a significant premium over the given share price. - This often leads to overpaying for the acquisition and subsequent shareholder value destruction—the so-called "winner's curse" - The market for corporate control is useful, however, when internal corporate-governance mechanisms have not functioned effectively and the company is underperforming.

Inside Directors

- Members who are generally part of the company's senior management team, such as the chief financial officer (CFO) and the chief operating officer (COO). - They are appointed by shareholders to provide the board with necessary information pertaining to the company's internal workings and performance. - As senior executives, however, inside board members' interests tend to align with management and the CEO rather than the shareholders.

Corporate Governance Mechanisms

- Play an important part in aligning the interests of principals and agents. - They enable closer monitoring and controlling, as well as provide incentives to align interests of principals and agents. - Perhaps even more important are the "most internal of control mechanisms": business ethics—a topic we discuss next.

Strategy and business ethics

- The principles, norms, and standards of business practice differ to some degree in different cultures around the globe. - Research studies have found that some notions—such as fairness, honesty, and reciprocity—are universal norms. As such, many of these values have been codified into law. - Law and ethics are NOT synonymous. This distinction is important and not always understood by the general public. Staying within the law is a "minimum acceptable standard" A manager's actions can be completely legal, but ethically questionable.

Market for Corporate Control

- important EXTERNAL corporate-governance mechanism - Consists of activist investors who seek to gain control of an underperforming corporation by buying shares of its stock in the open market. Corporate managers strive to protect shareholder value by delivering strong share-price performance or putting in place poison pills to avoid this. If a company is poorly managed, its performance suffers and its stock price falls as more and more investors sell their shares. Once shares fall to a low enough level, the firm may become the target of a hostile takeover Besides competitors, so-called "corporate raiders" or private equity firms and hedge funds may buy enough shares to exert control over a company.

While the board of directors is the central governance piece for a public stock company, several OTHER corporate mechanisms are also used to align incentives between principals and agents, including

1. Executive compensation. 2. The market for corporate control. 3. Financial statement auditors, government regulators, and industry analysts.

Porter recommends that managers focus on THREE things within the shared value creation framework

1. Expand the customer base to bring in NONCONSUMERS...such as those at the bottom of the pyramid—the largest but poorest socioeconomic group of the world's population. 2. Expand traditional internal firm value chains to include more NONTRADITIONAL PARTNERS... such as nongovernmental organizations (NGOs). - NGOs are nonprofit organizations that pursue a particular cause in public interest and are independent of any government (habitat for humanity, greenpeace) 3. Focus on creating new REGIONAL CLUSTERS.. such as Silicon Valley in the United States, Electronic City in Bangalore, India, and Chilecon Valley in Santiago, Chile. *these strategic actions will lead to a larger pie of revenues and profits that can be distributed among a company's stakeholders

2 Agency problems

1. adverse selection 2. moral hazard

The Public Stock Company: Hierarchy of Authority

1. state charter 2. shareholders 3. board of directors 4. management 5. employees

Shared Value Creation Framework

A model proposing that managers have a dual focus on shareholder value creation and value creation for society. guidance about how to reconcile the economic imperative of 1. gaining and sustaining competitive advantage 2. with corporate social responsibility. - It helps managers create a larger pie that benefits both shareholders and other stakeholders - externalities ( pollution, energy waste, costly accidents) create INTERNAL costs

Public Company

A public company is a company that has issued securities through an initial public offering (IPO) and is traded on at least one stock exchange or in the over the counter market.

Leveraged Buyout (LBO)

A single investor or group of investors buys, with the help of borrowed money (leveraged against the company's assets), the outstanding shares of a publicly traded company in order to take it PRIVATE. - LBO changes the ownership structure of a company from public to private. The expectation is often that the private owners will restructure the company and eventually take it public again through an initial public offering (IPO).

Moral Hazard

A situation in which information asymmetry increases the incentive of one party to take undue risks or shirk other responsibilities because the costs incur to the other party. example: bailing out homeowners from their mortgage obligations or bailing out banks from the consequences of undue risk-taking in lending are examples of moral hazard. The costs of default are rolled over to society ("other party") Knowing that there is a high probability of being bailed out ("too big to fail") increases moral hazard. In this scenario, any profits remain private, while losses become public

Adverse Selection

A situation that occurs when information asymmetry increases the likelihood of selecting inferior alternatives. - agent misrepresents his/her ability to do the job, gets hired, and struggles

Corporate Governance

A system of mechanisms to direct and control an enterprise in order to ensure that it pursues its strategic goals successfully and legally. -checks and balances and about asking the tough questions at the right time. - Attempts to address the principal-agent problem -The accounting scandals of the early 2000s and the global financial crisis of 2008 and beyond got so out of hand because the enterprises involved did not practice effective corporate governance.

Agency Theory

A theory that views the firm as a nexus of legal contracts corporations are viewed merely as a set of legal contracts between different parties. Conflicts that may arise are to be addressed in the legal realm. Such governance mechanisms are used to align incentives between principals and agents. These mechanisms need to be designed in such a fashion as to overcome two specific agency problems: 1. adverse selection 2. moral hazard

Pay and Performance

About two-thirds of CEO pay is linked to firm performance. The relationship between pay and performance is positive, but the link is weak at best. Agency theory would predict a positive link (weak) between pay and performance (this aligns incentives). Some recent experiments in behavioral economics caution that incentives that are too high-powered (e.g., outsized bonuses) may have a negative effect.

Agent vs. Principal

Agent can be a manager, and principal a share holder, or an employee can be an agent and her manager the principal. When agents act in their own self-interest it can be at the detriment of the firm as a whole (hence the principal agent problem). There are may examples of this from Enron and Tyco and Merrill Lynch in the B of A merger at the extreme, although an employee clocking in and using Facebook all morning while telling her boss she made sales calls is another example. Insider trading is an example of the principal agent problem and information asymmetry (e.g., at Goldman board member Rajat Gupta phoning a friend at a hedge fund after board meetings). The key it terms of strategic management here is to align strategy with the organizational design, processes and systems in a way to alleviate this, which involves good governance.

Employee Stock Options

An incentive mechanism to align the interests of shareholders and managers, by giving the recipient the right (but not the obligation) to buy a company's stock at a predetermined price sometime in the future

Outside Directors

Board members who are NOT employees of the firm, but who are frequently senior executives from other firms or full-time professionals. - Given their independence, they are more likely to watch out for the interests of shareholders

Poison Pill

Defensive provisions to deter hostile takeovers by making the target firm less attractive. - ex: allow existing shareholders to buy additional shares at a steep discount - have become RARE because they slow effective markets

Goldman Sachs "fabulous fab"

In 2010, the SEC sued the company and an employee, named Fabrice Tourre, for fraud. Did the bank knowingly mislead investors? Goldman Sachs argued that it is up to clients to assess risk involved in investments. Public pressure mounted. Goldman Sachs ended up paying $550M to settle the lawsuit, but did not admit wrongdoing. Tourre was convicted of fraud.

Uber

Most valuable private startup ever

Creating shared value

Porter argues that executives should NOT concentrate exclusively on increasing firm profits. Rather, the strategist should focus on creating shared value, a concept that involves creating economic value for shareholders while also creating social value by addressing society's needs and challenges.

Shareholder Capitalism

Shareholders—the providers of the necessary risk capital and the legal owners of public companies—have the most legitimate claim on profits.

Board of directors: Responsibilities

Strategic Goals and Initiatives General Strategic Oversight and Guidance Overall Resource Allocation Remuneration Review CEO Selection and Succession Evaluate Performance Overall Risk Mitigation

Board of Directors

The centerpiece of corporate governance, composed of inside and outside directors who are elected by the shareholders.

Codes of Conduct

The manager should imagine whether he or she would feel comfortable explaining and defending the decision in public. - How would the media report the business decision if it were to become public? How would the company's stakeholders feel about it?

4 advantages of public companies

The public stock company enjoys four characteristics that make it an attractive corporate form: 1. Limited liability for investors. - shareholders are only liable to the capital they invested 2. Transferability of investor ownership. 3. Legal personality. - a firm is similar to a person with legal rights and obligations. - allows continuation beyond the founders family 4. Separation of legal ownership and management control - the stockholders (principals, represented by a board) are the legal owners of the company and delegate the decision making to managers (agents)

Absolute Size of Pay Package

The ratio of CEO to average employee pay in the United States is about 300 to 1, up from roughly 40 to 1 in 1980. Based on a 2014 survey of CEOs among 300 large companies with revenues of at least $9 billion, the average salary for a CEO was $14 million.

Organizational culture

To foster ethical behavior in employees, boards must be clear in their ethical expectations, and top management must create an organizational structure, culture, and control system that values and encourages desired behavior. A company's formal and informal cultures must be aligned, and executive behavior must be in sync with the formally stated vision and values. Employees will quickly see through any duplicity. Actions by executives speak louder than words in vision statements.

Codes of conduct

To go beyond the minimum acceptable standard codified in law, many organizations have explicit codes of conduct. - These codes go above and beyond the law in detailing how the organization expects an employee to behave and to represent the company in business dealings - Codes of conduct allow an organization to overcome moral hazards and adverse selections as they attempt to resonate with employees' deeper values of justice, fairness, honesty, integrity, and reciprocity. Managers should consider... 1. When facing an ethical dilemma, a manager can ask whether the intended course of action falls within the ACCEPTABLE NORMS OF PROFESSIONAL BEHAVIOR as outlined in the organization's code of conduct and defined by the profession at large. 2. imagine whether he/she would be comfortable EXPLAINING AND DEFENDING the decision in PUBLIC

Executive Compensation

Two issues of CEO compensation: 1. The absolute size of the CEO pay package compared with the pay of the average employee. 2. The relationship between CEO pay and firm performance.

Business Ethics

agreed upon code of conduct in business, based on societal norms Business ethics lay the foundation and provide training for "behavior that is consistent with the principles, norms, and standards of business practice that have been agreed upon by society." - Multiple, high-profile accounting scandals and the global financial crisis have placed business ethics center stage in the public eye.

CEO/chairperson duality

being the CEO and holding a chair on the board - has been DECREASING in recent years

fiduciary responsibility

legal duty to act solely in another party's interest -- toward the shareholder because of the trust placed in him/her

Unicorns

private startup companies valued at 1+Billion - tech sector has the most unicorns

Key advantage to publicly traded company

separation of ownership and control - but this can lead to the principal-agent problem - problem: information asymmetry: the agents are usually more informed than the principals

The ethical pursuit of competitive advantage lays the foundation for long-term superior performance.

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