chapter 12 corporate governance

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. -is about checks and balances and about asking the tough questions at the right time

Shared Value Creation Framework

-The shared value creation framework provides guidance to managers about how to reconcile the economic imperative of gaining and sustaining competitive advantage with corporate social responsibility. -helps managers create a larger pie that benefits both shareholders and other stakeholders

Poison Pill (part of external governance mechanisms: the market for corporate control)

Defensive provisions to deter hostile takeovers by making the target firm less attractive.

GE on creating shared value

General Electric recognizes a convergence between shareholders and stakeholders to create shared value. To ensure that convergence indeed takes place, companies need effective governance mechanisms

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

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

hierarchy of authority for public company

state charter-->shareholders-->BOD-->Management-->employees

Leveraged Buyout (LBO) which is part of governance mechanism of the market for corporate control

-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. -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 and example

-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. -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. Knowing that there is a high probability of being bailed out ("too big to fail") increases moral hazard

Agency Theory

-A theory that views the firm as a nexus of legal contracts. -In this perspective, 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: adverse selection and moral hazard.

Auditors, Regulators, Analysts

-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).

Other governance mechanisms: auditors, government regulators and industry 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.

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.

Other governance mechanisms: The market for corporate control

-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 (e.g., Carl Icahn and T. Boone Pickens) or private equity firms and hedge funds (e.g., The Blackstone Group and Pershing Square Capital Management) may buy enough shares to exert control over a company.

elements of executive compensation

-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. -Absolute size of pay package -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 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.

other corporate mechanisms used to align incentives between principals and agents besides the BOD

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

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.

law vs ethics

-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.

Inside Directors

-Members of the BOD 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. -tend to align with management and the CEO rather than the shareholders.

importance of 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.

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

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.

why do organizations have codes of conduct

-To go beyond the minimum acceptable standard codified in law -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.

how 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.

acceptable norms of professional behavior

-outlined in the organization's code of conduct and defined by the profession at large -When facing an ethical dilemma, a manager can ask whether the intended course of action falls within the acceptable norms of professional behavior

3 parts of the Shared Value Creation Framework (in line with the stakeholder theory)

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). 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.

4 advantages of public company

1)Limited liability for investors. 2)Transferability of investor ownership. 3)Legal personality. 4)Separation of legal ownership and management control.

Shared Value Creation Framework

A model proposing that managers have a dual focus on shareholder value creation and value creation for society.

adverse selection

A situation that occurs when information asymmetry increases the likelihood of selecting inferior alternatives.

what should the manager ask him/herself when deciding if 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?

Porter on 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.

BOD responsibilities

Selecting, evaluating, and compensating the CEO. The CEO reports to the board. Should the CEO lose the board's confidence, the board may fire him or her. Overseeing the company's CEO succession plan. Providing guidance to the CEO in the selection, evaluation, and compensation of other senior executives. Reviewing, monitoring, evaluating, and approving any significant strategic initiatives and corporate actions such as large acquisitions. Conducting a thorough risk assessment and proposing options to mitigate risk. The boards of directors of the financial firms at the center of the global financial crisis were faulted for not noticing or not appreciating the risks the firms were exposed to. Ensuring that the firm's audited financial statements represent a true and accurate picture of the firm. Ensuring the firm's compliance with laws and regulations.

what lays the foundation for long term superior performance

The ethical pursuit of competitive advantage

Other governance mechanisms: Executive compensation

The topic of executive compensation—and CEO pay, in particular—has attracted significant attention in recent years. Two issues are at the forefront: 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.

*importance of 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.

the one social responsibility of business according to Milton Friedman

business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud

public company

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.

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."

when is the market for corporate control useful

when internal corporate-governance mechanisms have not functioned effectively and the company is underperforming.