Chapter 12 - Corporate Governance and Business Ethics

Preferences over risky outcomes

Different people will have different risk tolerances --Firms tend to be more risk neutral than agents Employee payoff under risk will be

Selecting Performance Measures

A good measure Should not have a huge random component Should encourage desirable activities and discourage undesirable activities Measures could be absolute measures or relative measures Relative measures reduce risk due to common effects but may also encourage sabotage

What is a corporation?

A legal entity that's separate from its owners. Have an independent life separate from its shareholders. Offer the strongest protection to its owners Cost to form a corporation is higher than other structures.

Limited liability for investors

Encourages investments and risk-taking

Creating shared value

Executives should focus on creating shared value by 1.Expanding the customer base --Bring in nonconsumers (largest and poorest groups) 2.Expanding traditional internal firm value chains. --Include more nontraditional partners (non-profits) 3.Focusing on creating new regional clusters: --Such as Silicon Valley

Solution for emergence of CSR

Focus on tension between business and society rather than their interdependence Generic rationale not tied to firm's strategy Solution: Shared Value Creation framework

Environmental, social and governance (ESG)

Framework for analyzing companies in terms of these metrics Environmental Water usage, waste production, etc Social How do they treat clients, workers, and diversity aspects Governance Share class structure, governance structure

Outside Directors

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

Transferability of investor ownership

Trading of shares of stock

The Public Stock Company: Four Benefits

-limited liability for investors -transferability of investor ownership -legal personality -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 § Porter argues that executives should not concentrate exclusively on increasing firm values. 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

The market for corporate control

Activist investors who: Seek to gain control of an underperforming corporation Buy shares of its stock in the open market Through leveraged buy outs - from public to private (firing the shareholders) Defended by poison pills Existing managers are usually fired

Limitations for performance measures

Activities important to the firm may not be reflected in the performance measures. --Test-based incentives for teachers Activities detrimental to the firm may have a positive effect on the "performance measures." --Conflicts over overhead cost allocation

Business Ethics

An agreed-upon code of conduct in business Provides training for: "behavior that is consistent with the principles, norms, and standards of business practice that have been agreed upon by society" Can differ in various cultures around the globe Universal norms include: Fairness, honesty, reciprocity

Bad apples vs Bad barrels

Bad Apples (individuals) vs Bad Barrels (organizations) To set the ethical tone, leaders must: Set clear ethical expectations Put structure, culture and control systems in place Culture must be aligned Executive behavior must adhere to values

Adverse Selection and Moral Hazard

Both caused by information asymmetry Adverse Selection --An increased likelihood of selecting inferior alternatives Moral Hazard --When one party is incentivized to take undue risks or shirk responsibilities because the costs incur to the another party

Efficiency wages and threat of termination

Idea: Pay wage higher than what employee could get in the market If employee is caught shirking, fire him/her Firing is a punishment if wages are higher than what is available in the market Depends on probability of detection Manager effort? Can increase employee general satisfaction

Risk and incentives Key Points

Key points: The firm will prefer stronger incentives (commission closer to 100%) if: •The employee is less risk averse •The variance (noise) of measured performance is lower •The employee's marginal cost of effort is lower •The marginal return to effort is higher

Legal personality

Rights and obligations - allows a firm to live indefinitely

Corporate Social Responsibility Emergence

Many companies awoke to Corporate Social Responsibility (CSR) after public response Activists have been more vocal and effective Response from firms is mostly cosmetic, not operational Usually there is no coherent framework for CSR activities

Monitoring Disadvantages

Monitoring can be expensive --Span of control --Take time from manager Monitoring is often imperfect

Prevailing Justifications for CSR

Moral obligation --Companies have a duty to "do the right thing" Sustainability --Emphasizes environmental and community stewardship (think of the future generations) License to operate --Companies need tacit or explicit permission from governments, communities, and other stakeholders Reputation --Improve a company's image, strengthen its brand, invigorate morale

Performance-based incentives

Principal links agents' pay to outcome from agent's actions Examples --Sales commissions --Stock options for executives --Non-monetary rewards

Separation of ownership and control

Principal-agent problem

Responsibilities of the board of directors

Strategic oversight and guidance CEO selection, evaluation, compensation Guide executive compensation Review, monitor, evaluate, and approve strategic initiatives Risk assessment & mitigation

Auditors, Government Regulators, and Industry Analysts

To avoid misrepresentation of financial results: Public financial statements must follow GAAP: Generally accepted accounting principles Financial statements must be audited Industry analysts often base their recommendations on: Financial statements filed with the SEC Business news (WSJ, Forbes, CNBC, etc.)

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 The mechanisms to: --Direct and control an enterprise --Ensure that it pursues strategic goals successfully and legally Offers checks and balances Attempts to address the principal-agent problem

The Board of Directors

centerpiece of corporate governance, composed of inside and outside directors who are elected by the shareholders Represent the interests of shareholders --Elected by the shareholders Tasked with providing oversight Consist of inside and outside directors

Inside Directors

members who are generally part of the company's senior management team, such as the CFO and the COO

How to solve principal-agent problem

monitoring and Performance based incentives

Corporate governance explained

o Is about checks and balances and about asking the tough questions at the right time o 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.

shareholder capitalism

shareholders - the providers of the necessary risk capital and the legal owners of public companies - have the most legitimate claim on profits