Chapter 10 - corporate governance

Board of directors

- Group of elected individuals that acts in the owners' interests and - formally monitor and control the firm's top-level executives

Enhancing the effectiveness of boards and directors

- Increase diversity in the backgrounds of board members - Strengthen internal management and accounting control systems - Establish formal processes to evaluate the board's performance - Create a "lead director" role (With strong powers over board agenda and activities) - Require that outside directors own significant equity stakes in the firm (But, it can lead to lower independence)

Market for corporate control

- Individuals and firms buy or take over undervalued firms (Ineffective managers are usually replaced in such takeovers) - Threat of takeover may lead firm to operate more efficiently - Changes in regulations have made hostile takeovers difficult

Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010

- Most sweeping set of financial reforms in almost a century - Created a Financial Stability Oversight Council headed by the Treasury Secretary - Established a new system for liquidation of certain financial companies - Provided for a new framework to regulate derivatives - Established new corporate governance requirements - Regulated credit rating agencies - Established a new consumer protection bureau and provided for extensive consumer protection in financial services

Japan Important governance factors:

- Obligation - "Family" - Consensus concerned with a broader set of stakeholders banks are highly influential

Governance Mechanisms

- Ownership concentration - board of directors - executive compensation - market for corporate control

Effectiveness of executive compensation

- Performance-based compensation used to motivate decisions in shareholder interest - Incentive-based compensation plans intended to increase firm value

SOX has led to positive outcomes

- Protection of shareholders - Improved transparency and internal controls in accounting and auditing But, - increased costs to firms - Decrease in foreign firm listing on U.S. exchanges

Separation between ownership and management control can lead to problems because:

- Shareholders lack direct control of large, publicly traded corporations - Agent makes decisions that result in the pursuit of goals that conflict with those of the principal - It is difficult or expensive for the principal to verify whether the agent has behaved appropriately - Principal and agent have divergent interests and goals - Agent falls prey to managerial opportunism

Factors complicating executive compensation

- Strategic decisions by top-level managers are complex, non-routine and - affect the firm over an extended period - Alignment of pay and performance: complicated board responsibility - So, tendency to link financial performance with pay - But other environmental variables affect the firm's performance over time

Ownership concentration

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

Board has the power to

- direct the affairs of the organization - punish and reward managers - protect owners from managerial opportunism

Institutional Owners (stock mutual funds & pension funds)

- have the size (proxy voting power) and - incentive (demand for returns to funds) - to discipline ineffective top-level managers - can affect the firm's choice of strategies - control over 60-75% of stock in U.S. firms

Composition of Boards

- insiders ( the firm's CEO and other top-level managers) - related outsiders (individuals uninvolved with day-to-day operations, but who have a relationship with the firm) (large suppliers) -outsiders ( individuals who are independent of the firm's day-to-day operations and other relationships) (president of a university)

Large block shareholders have a strong incentive to monitor management closely:

- investors who own atleast 5 percent of firms shares - may obtain board seats , which allows them to monitor effectively - Institutional owners have replaced individuals as large block shareholders

ethical behavior

- societal culture - personal ethics - organization culture - unrealistic performance goals - leadership decision-making processes

The differences between governance systems fall into four main categories:

1. accounting 2. company boards 3. company bosses 4. Rewards

It is concerned with:

1. strengthening the effectiveness of a company's board of directors 2. verifying the transparency of a firm's operations 3. enhancing accountability to shareholders 4. incentivizing executives 5. maximizing value-creation for stakeholders and shareholders

Managerial defense tactics increase the costs of mounting a takeover defense tactics:

Asset restructuring (Divesting a business unit) Changes in the financial structure of the firm (Stock repurchases) Making targeted shareholder repurchases (aka greenmail)

Company Boards

Biggest distinction exists between Germany and rest of the world German system - two boards Supervisory board and a management board Other countries have one But vary in composition and its powers

3 large banks - (Germany)

Deutsche, Dresdner, and Commerzbank—hold majority positions in large German firms Banks monitor & control managers

In the aftermath of the financial crisis, U.S. Congress enacted:

Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010

accounting

Enables investors to see what managers are doing with their money Accounts prepared under different countries' rules produce very different results

Rewards

Europe and Japan - rewarded with salary and bonuses US - rewarded with shares and share options US top executive takes home about 400 times the pay of his firm's lowest paid worker European and Asian top executive takes home about 10 times the pay of her firm's lowest paid worker

Agency costs & governance mechanisms

Firms incur costs in using governance mechanisms: Agency Costs Sum of: - incentive costs - monitoring costs - enforcement costs - individual financial losses incurred by principals Tend to be higher for diversified firms

Corporate Directors should:

Focus on creating long-term value for shareholders Use performance-related pay to attract and retain senior management Exercise sound business judgment to evaluate opportunities and manage risk Promote greater diversity and transparency Communicate with key shareholders

Company Bosses

Good governance begins at the top: US - CEO given free rein to run things as much as they like UK - role of chairman and CEO is separate Germany - CEOs are watched by the supervisory board France - CEO are watched by the government

Separation of Ownership and Managerial Control

In small firms: managers are high percentage owners implies less separation between ownership and management control

Board of Directors

Individuals responsible for representing the firm's owners by monitoring top-level managers' strategic decisions

Market for Corporate Control

Is a set of potential owners seeking to acquire undervalued firms

Goal: (executive compensation)

Long-term incentive compensation in place

Germany (two tiered Board)

Management board Supervisory Board

Supervisory Board (Aufsichtsrat)

Monitors and controls managerial decisions Responsible for appointing members to the Vorstand (or management board)

Germany

Owner and manager are often the same in private firms Public firms often have a dominant shareholder, frequently a bank Frequently there is less emphasis on shareholder value than in U.S. firms may be changing as German firms are gravitating toward U.S. governance mechanisms

Ownership Concentration

Represented by types of shareholders and their different incentives to monitor managers

Employees Union members shareholders (Germany)

Responsible for appointing members to the Aufsichtsrat (or supervisory board)

Management board (Vorstand)

Responsible for the functions of strategic direction and management

Forms of compensation

Salaries, bonuses, long-term performance incentives, stock awards, stock options

Growth of the large, modern public corporation is based primarily on the:

Separation of ownership and managerial control As a result: - Shareholders bear risk - Managers formulate and implement strategy - Managers are compensated for their decision-making skills

Sarbanes-Oxley (SOX) Act in 2002

Set expanded requirements for public company boards, management and public accounting firms

Executive compensation:

a governance mechanism that seeks to align managers' and owners' interests through salary, bonus, and long-term incentive compensation

Diffuse Ownership

a large number of shareholders with small holdings and few or no large-block shareholder: - Produces weak monitoring of managerial decisions - Makes it difficult for owners to coordinate their actions effectively - May result in levels of diversification that are beyond the optimum level desired by shareholders So, boards of directors have become important to corporate governance

shareholder activism

institutional and other large block shareholders make active efforts to influence corporations' strategic direction - shareholders can convene to discuss corporation's direction

As firms grow, they face two issues:

may need to seek outside capital : - whereby they give up some ownership control may not have access to all needed skills to manage the growing firm: - so may need outsiders to improve management

Corporate governance involves :

oversight in areas where owners, managers and members of boards of directors may have conflicts of interest.

In response to major corporate and accounting scandals, U.S. Congress enacted:

sarbanes- Oxley (SOX) Act in 2002

Managerial opportunism is:

seeking self-interest with guile (i.e. deceit) opportunism represented by: - an attitude (inclination) and - a set of behaviors (specific acts of self-interest) Managerial opportunism prevents the maximization of shareholders wealth

agency relationship

the separation between owners & managers creates an agency relationship

Corporate governance:

the set of mechanisms used by organizations to: - manage relationships among stakeholders and - determine and control the strategic direction of organizations - Used to establish harmony between the firm's owners (aka shareholders) and its top-level managers whose interests may be in conflict

Executive Compensation

use of salary, bonuses, and long-term incentives to align managers' interests with shareholders' interests