Ch 12- Corporate Governance and Business Ethics

incentives

Dan Pink and his Ted Talk. Think about the complexity of incentives. If, then rewards work well for a simple set of rules and a narrow focus towards a goal

Poison pill

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

Milton Friedman's philosophy

"the social responsibility of business is to increase its profits." The countries where the fewest people agreed with Friedman's philosophy were China, Brazil, Germany, Italy, and Spain The United Arab Emirates (UAE), a small and business-friendly federation of seven emirates, had the highest level of agreement, at 84 percent

The public stock company enjoys four characteristics that make it an attractive corporate form

1. Limited liability for investors- shareholders who provide the risk capital are liable only to the capital specifically invested, not for other investments they may have made or for their personal wealth. Limited liability encourages investments by the wider public and entrepreneurial risk-taking. 2. Transferability of investor ownership through the trading of shares of stock on exchanges. Each share represents only a minute fraction of ownership in a company, thus easing transferability. 3. Legal personality—the law regards a non-living entity such as a for-profit firm as similar to a person, with legal rights and obligations. Legal personality allows a firm's continuation beyond the founder or the founder's family. 4. Separation of legal ownership and management control. In publicly traded companies, the stockholders (the principals, represented by the board of directors) are the legal owners of the company, and they delegate decision-making authority to professional managers (the agents)

Evolution of the modern corporation

1. Startup- funding is personal savings/family/friends. Governance climate is 1 of a few owners with ownership and control together and managed by founder/owner. No resulting agency problem. 2. Product takes off- funding is bank loans. But everything else the same as startup. 3. Prof. Management- funding is bank loans. Governance climate is 1 of a few owners with ownership and control together and managed a hired professional. Low resulting agency problem. Remedies: Founder monitoring (e.g., bank stmt, fin. stmts, office visits) 4. Intense demand for product- funding is capital market. This breaks up governance climate and ownership and control between shareholders and hired management. Resulting Agency problem is med/high. Remedies: Activist shareholders, Mkt for corp control, Incentives, Boards

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. Better return for buyers Discipline of debt service Can kill value if target can't handle interest expense

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. Describes the difficulty of the principal to ascertain whether the agent has really put forth a best effort. In this situation, the agent is able to do the work but may decide not to do so.

adverse selection

A situation that occurs when information asymmetry increases the likelihood of selecting inferior alternatives. Describes a situation in which an agent misrepresents his or her ability to do the job

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. Designed to manage risk and prevent abuse by executives attempts to address the principal-agent problem A lot of things influence it (unions, auditors, boards, etc.)

inside directors

Board members who are generally part of the company's senior management team; appointed by shareholders to provide the board with necessary information pertaining to the company's internal workings and performance. Appointed by shareholders to provide the board with necessary information pertain- ing to the company's internal workings and performance. But, inside board members' interests tend to align with management and the CEO rather than the shareholders

outside directors

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

Mechanisms to overcome the principal-agent problems

Board of directors Other governance mechanisms (Executive compensation/Incentives, The market for corporate control, Auditors, government regulators, and industry analysts)

business ethics

An agreed-upon code of conduct in business, based on societal norms. Differ to some degree in different cultures around the globe. Staying within the law is a minimum acceptable standard. To go beyond the minimterm-13um acceptable standard codified in law, many organizations have explicit codes of conduct To foster ethical behavior in employees, boards must be clear in their ethical expecta- tions, and top management must create an organizational structure, culture, and control system that values and encourages desired behavior. Furthermore, a company's formal and informal cultures must be aligned, and executive behavior must be in sync with the formally stated vision and value

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

corporate raiders

Henry Kravis, Carl Ichan Gordon Gekko (from movie) "greed is good" speech

Trends in governance: Sarbanes-Oxley Act of 2002

Intended to increase the accountability of managers to shareholders, thus calming the crisis of confidence in American capitalism Highlights: - Holds managers & directors personally accountable for upholding fiduciary responsibilities - Enhances reporting and disclosure requirements - Increases independence of boards & committees - Provides better protection for whistleblowers

WTP for a company

Investors are willing to pay 16% more for a company if it is known to have a good corporate governance 16% of the 30% premium

Activist Shareholders

Large institutional investors own 60% of US equities Strong incentives to monitor managementLarge stakesInvestment performance critical to meeting liabilities/obligations Influence strategies- "voice" instead of "exit" 922 global companies were subject to AS demands last year Drive investor confidence Opposite to market for corporate control

Trends in Governance: Boards

More active boards; intervention in strategic decision-making increasingly common Increased representation of outside, non-affiliated directors Re-balancing of power between management & board - split CEO/Chairman roles Greater stock ownership by managers & directors Monitoring & rating of governance practices by intermediaries (ISS, Corporate Library)

Principal-agent problem

Separation of ownership and control in public companies helps lead to the principal-agent problem. When either the principal or the agent owns the decision making or ownership, it brings the two together and this is what we're looking for The risk of opportunism on behalf of agents is exacerbated by information asymmetry: the agents are generally better informed than the principals. Information asymmetry also can breed on-the-job consumption. Such uses of company funds, in effect, mean that shareholders pay for those items and activities

shareholder capitalism

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

CEO/chairperson duality

Situation where the CEO of a publicly traded company is also the chairperson of the board of directors. Huge problem for corporate governance The company's CEO reports to the board of directors and acts as a liaison between the company and the board. The CEO has high-level responsibilities of strategy and all other management activities of a company while the functions of the board of directors include approving the annual budget and dealing with stakeholders

Executive compensation

The board of directors determines executive compensation packages. To align incentives between shareholders and management, the board frequently grants stock options as part of the compensation package. The absolute size of the CEO pay package compared with the pay of the average employee has been looked at recently

board of directors

The centerpiece of corporate governance, composed of inside and outside directors who are elected by the shareholders to represent their interests Fiduciary responsibility—a legal duty to act solely in another party's interests Hire, fire & monitor top management Review & approve resource commitments Participate in setting overall direction & strategy for firm BUT Active monitoring and control behaviors associated with fewer board appointments No relationship between firm performance & board appointments Some evidence that directors are punished for visible corporate failures (bankruptcy, fraud) Director appointments based on: - Demographic characteristics - Social connections - Ingratiating behaviors Technically a person cannot serve on the boards of competitors

shared value creation framework

a model proposing that managers have a dual focus on shareholder value creation and value creation for society. Recognizes that markets are defined not only by economic needs but also by societal needs. It also advances the perspective that externalities such as pollution, wasted energy, and costly accidents actually create internal costs, at least in lost reputation if not directly on the bottom line

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 principal-agent problem is a core part of this cascade down the organizational hierarchy frontline employees often enjoy an informational advantage over management. They may tell their supervisor that it took longer to complete a project or serve a customer than it actually did, for example. Some employees may be tempted to use such informational advantage for their own self-interest The firm needs to design work tasks, incentives, and employment contracts and other control mechanisms in ways that minimize opportunism by agents. Need to be designed in such a fashion as to overcome two specific agency problems: adverse selection and moral hazard

Porter

argues that executives should not concentrate exclusively on increasing firm profits. Rather, the strategist should focus on creating shared value 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. The bottom of the pyramid in the global economy can yield significant business opportunities, which could improve the living standard of the world's poorest 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. Lead to a larger pie of revenues and profits that can be distributed among a company's stakeholders (stakeholder theory)

The market for corporate control

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. To avoid such attempts, corporate managers strive to protect shareholder value by delivering strong share-price performance or putting in place poison pills. Fight back against this takeover because they will be fired when they get taken over (examples include Golden parachute, Pac man defense, White knight, white squire, Crown jewels) 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 leveraged buyout The market for corporate control is a 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. 70s and 80s companies buying up other companies that didn't make sense

Auditors, government regulators, and industry analysts

the SEC makes all financial reports filed by public companies available electronically via the EDGAR database. Industry analysts scrutinize these reports in great detail, trying to identify any financial irregularities and assess firm performance. Researchers have questioned the independence of industry analysts and credit-rating agencies that evaluate companies, because the investment banks and rating agencies frequently have lucrative business relationships with the companies they are supposed to evaluate, creating conflicts of interest